File 127365

Master Thesis
MSc. Finance
The Determinants of Capital Structure: A Comparative

Study of Public and Private Firms
Submitted by: Z. Afzal

ANR: 465562
Supervisor: dr. M. Da Rin
Chair Person: dr. F. Feriozzi
Date: 21 September, 2012
Abstract
This paper investigates the determinants of capital structure of a large sample of quoted and
unquoted firms incorporated in the United Kingdom, The Netherlands and Germany. It explores
whether the traditional determinants of leverage of quoted firms, namely firm size, profitability,
tangibility, growth and earnings volatility also hold across unquoted firms. Further, I attempt to
analyse the differences in capital structure and financing behaviour of quoted and unquoted
firms. My findings suggest that private firms have significantly higher leverage than public
firms. Also, my results support the traditional determinants of leverage. In the case of public
firms, leverage is positively correlated to size, tangibility and volatility and negatively correlated
with profitability. In the case of private firms, leverage appears to be positively correlated with
growth, tangibility and volatility and negatively correlated with size and profitability, ceteris
paribus. Hence, there seems to be a difference in the financing behaviour of public and private
firms with regards to size and growth opportunities. However, a critical finding of my study is
the importance of institutional factors in the determination of capital structure of firms. Firms in
the Netherlands are less levered whereas those in Germany are more highly levered as compared
to the firms in the United Kingdom.
ii
Table of Contents
I.
Introduction..1
II.
Theoretical Framework.4
A. The Pecking Order Theory..4
B. The Trade-off Theory..5
C. The Agency Theory.5
D. The Signalling Theory.6
E. Determinants of Leverage...7
E.1. Overview..7
E.2. Size.11
E.3. Asset Tangibility....12
E.4. Growth...12
E.5. Profitability13
E.6. Earnings Volatility.14
F. Differences in Capital Structure of Public and Private Firms.14
F.1. Access to Capital Market15
F.2. Information Asymmetry..........15
F.3. Ownership Concentration...15
G. Institutional Factors...16
III.
Hypothesis Development...18
iii
IV.
Data..19
A. Sources...19
B. Sample20
C. Research Methodology...22
D. Variable Measurement....23
E. Descriptive Statistics......26
V.
Empirical Results.30
A. Multivariate Analysis.30
B. Cross-Country Analysis.34
C. Analysis of Variance..36
D. Institutional Differences.37
E. Robustness Tests39
F. Limitations.44
VI.
Conclusion...44
References...46
Appendix.50
iv
Determinants of Capital Structure:

A Comparative Study of Public and Private Firms
I.
Introduction
The influential paper of Modigliani and Miller on capital structure irrelevancy has been
followed by extensive theoretical research to determine the optimal capital structure.
Modigliani and Miller show that firm value is independent of the capital structure under the
strict assumptions of perfect and frictionless capital markets (1958). However, in reality
market frictions exist. Latter literature has been devoted to studying these market
imperfections in order to determine optimal capital structure. Four main theories have been
proposed since then which attempt to explain the amount of leverage to be undertaken
through a cost-benefit analysis of leverage. These theories try to explain the choices behind
corporate financing sources in light of potential costs associated with each source vis--vis
agency, information asymmetry, transaction and bankruptcy costs.
There have been extensive empirical studies investigating the theories of capital structure.
These studies have identified certain key determinants of leverage such as collateral value of
assets, firm size, growth opportunities and profitability amongst many (Titman and Wessels,
1988; Harris and Raviv, 1991; Rajan and Zingales, 1995). However, these studies have
almost exclusively focused on public firms due to data availability. Consequently, this leaves
a gap in the literature focusing on the financing behaviour of private firms. It is assumed that
the general theories of capital structure are applicable across the private sector as well.
However, this may not be the case as public and private firms are inherently faced with
different costs of financing. This may lead to different financing choices. Public firms have
access to capital markets whereas this access is limited for private firms. As a result, private
firms face relatively higher costs of both debt and equity (Brav, 2009).
Other than these traditional firm-specific characteristics, certain institutional factors may
determine the capital structure of a firm. Differences in bankruptcy and tax laws, lenderborrower relationship, ownership concentration and financial orientation may also effect
leverage (Rajan and Zingales, 1995; Antoniou et al., 2008). To give an example, Germany
and the United Kingdom have strict creditor rights in place as compared to the Netherlands
(La Porta et al., 1998). This might lead us to observe relatively higher leverage in the UK and
Germany as suppliers would be more willing to lend if their rights are well-protected. Similar
differences persist across countries depending on their legal traditions which might dictate
leverage.

Fundamental questions thus arise as to whether the predictions offered by the theories of
capital structure are also applicable to private firms. If not, then what drives the capital
structure of private firms and how does that differ from its public counterpart. Are the
stylized factors determining private firm leverage different from those of public firms? Also,
are factors other than firm-specific characteristics such as institutional setup important
determinants of leverage? The objective of my study is to answer these questions.
I attempt to identify the characteristics that determine the leverage of unquoted firms and to
analyse the differences between the capital structure of public and private firms. I further
extend my investigation to provide a cross country analysis of the differences in leverage. I
try to explain these differences in light of institutional factors facing each country. This paper
thus explores two key areas in the field of corporate finance. It first examines the
determinants of capital structure of private firms based on a large sample of private firms in
the United Kingdom, the Netherlands and Germany for the period 2003-2011. Second, it
incorporates the effects of the legal economy in which the firm operates on leverage by
providing a cross-country comparison.
I limit myself to the study of five firm-specific factors, namely, asset tangibility, profitability,
growth, size and earnings volatility. Four of these factors (asset tangibility, profitability,
growth and size) have been identified as being consistent determinants of leverage, namely,
asset tangibility, profitability, growth, size and earnings volatility (Bradley et al., 1984; Rajan
and Zingales, 1995; Frank and Goyal, 20071). However, these have been found to be
consistent factors for public firms only. Some initial studies on private sector by Deloof and
Verschueren (1998) and Schoubben and Hulle (2004) find a significant relationship between
earnings volatility and leverage. Hence, I include this variable in my analysis as well.
My choice of the three countries is motivated by two reasons. First, these countries are the
financial hubs of Europe. Hence, access to capital markets can be considered homogenous
across the countries and does not bias my analysis. Second, these countries are characterized
by different legal traditions. The UK is defined by the English legal origin, Germany by the
Germanic legal origin and the Netherlands by the French legal origin. Therefore, these
countries provide me with an ideal data set to study the relationship between institutional
factors and leverage.
1
Frank and Goyal (2007) also find industry mean leverage to be a reliable determinant of capital structure.
However, I exclude this from my analysis as I introduce industry fixed effects in my analysis to control for
inherent variation across industries.

There are certain limitations to the existing literature on capital structure. Due to data
limitations, the study on private firms has largely been neglected. Results derived from the
study of public firms are generalized to the private firms. Since studies have focused
primarily on firm-specific characteristics only, this leaves a gap between the relationship of
capital structure with institutional factors which might be very important. Also, a significant
portion of current literature is based on cross-sectional data. My study thus contributes to the
existing literature in three ways. First, it extends the existing empirical analysis of firmspecific determinants of leverage to the private sector. Second, it incorporates an analysis of
institutional factors in the study of capital structure. Third, the application of panel data
reduces the collinearity among explanatory variables and gives more efficient coefficients
(Hsiao, 1985).
My findings suggest that private firms have significantly higher leverage than public firms.
Also, my results support the traditional determinants of leverage. In the case of public firms,
leverage is positively correlated to size, tangibility and volatility and negatively correlated
with profitability. The relationship with growth is statistically insignificant. In the case of
private firms, leverage appears to be positively correlated with growth, tangibility and
volatility and negatively correlated with size and profitability, ceteris paribus. Hence, there
seems to be a difference in the financing behaviour of public and private firms with regards to
size and growth opportunities.
However, a critical finding of my study is the importance of institutional factors in the
determination of capital structure of firms. Firms in the Netherlands are less levered whereas
those in Germany are more highly levered as compared to the firms in the United Kingdom.
This can be explained in terms of creditor rights protection. As the legal origin of the
Netherlands allows for poor creditor protection, in terms of bankruptcy laws, reorganization
and automatic stays, Dutch firms have lower leverage. This may be explained by possibly a
higher cost of debt in the Netherlands to incorporate the higher risk that lenders face.
The following paper is organized as follows: In Section II, I review the existing literature on
the subject; in Section III, I develop my hypothesis in light of the empirical evidence; in
Section IV, I discuss the sample and my research methodology; in Section V, I comment on
the empirical findings of the study followed by the limitations; and in Section VI, I conclude
and draw reference to the future scope of the research.

II.
Theoretical Framework
Four main theories have been proposed which provide some insight into the financing
behavior of firms. These theories hypothesize the amount of leverage to be undertaken
through a cost-benefit analysis of leverage. The benefits of debt as a source of capital
primarily include the tax-advantage of debt as interest expense is tax deductible. On the other
side, potential costs of debt are the agency costs, bankruptcy costs and the loss of non-debt
tax shields (Brealy and Myers, 2002). Theoretically, the optimal capital structure then
involves a careful balancing between these costs and benefits. A brief overview of the
theories put forth is as follows:
A. The Pecking Order Theory
According to this theory, the firms follow a financing hierarchy due to information costs
(Myers and Majluf, 1984). Firms primarily face two potential costs when they approach the
external markets to raise capital, information asymmetry costs and transaction costs. These
additional costs make external capital more expensive and naturally lead firms to use internal
over external funds.
Information asymmetry arises due to the separation of ownership and management. Managers
have more information about the value of the firm and would attempt to issue equity when its
market value is higher (Myers and Majluf, 1984). Due to this information asymmetry
between outside investors and managers, equity may be under-priced to account for this
managerial incentive. This may make equity an expensive source of financing and lead firms
to under-invest. Retained earnings are unaffected by such problems. Also, as debt requires
fixed payments of interest, it is less sensitive to information asymmetries.
Similarly, transaction costs can dictate a firms sources of financing. Baskin (1989) has found
that costs for borrowing can be as low as 1% of the amount raised whereas the costs for
issuing equity are anywhere between 4% and 15% of the total amount. This evidence
suggests that debt would be a preferred source of external financing compared to equity.
Taking these costs into consideration, firms will prefer internal financing to external
financing, and debt to equity in the event of external financing (Donaldoson, 1961). This
theory suggests that there is no optimal capital structure. In fact the capital structure is a

function of the firms needs to tap the external markets when internal funds are insufficient to
meet investment opportunities.
B. The Trade-off Theory
This theory is an off-shoot of the Modigliani and Miller model. Interest expense is tax
deductible. Hence, a larger interest expense will result in lower taxable profits and
consequently lower taxes. By increasing the amount of debt on their balance sheets, firms can
derive tax benefit through the interest tax shield. However, increasing debt can also increase
financial distress. With very high levels of debt, firms may be unable to meet their debt
obligations increasing the probability of default. There is thus a trade-off between the costs
and benefits of debt.
Firms are faced with a diminishing marginal benefit of debt and an increasing marginal cost
of debt. In an attempt to maximize value, firms would then borrow up to a point where the
marginal tax benefit is offset by the marginal costs of bankruptcy (Myers, 1984).
C. The Agency Theory
Agency costs stem from the separation of ownership and management which inherently leads
to a conflict of interest between the managers and the shareholders. A classical case of the
agency problem has been put forth by Jensen (1986) also known as the free cash flow
problem. He argues that the managers of a firm having excess free cash flows may overinvest and engage in value destroying activities such as empire building. Firms can thereby
increase leverage to discipline the managers. Increased leverage commits management to pay
out the excess free cash flows in interest payments and invest in profitable ventures to service
the debt. In such a case, leverage maybe desirable even when internal funds are available. It
serves as a control mechanism to discipline managers and limits the expropriation of private
benefits (Jensen, 1986; Dewatripont and Tirole, 1994; Lewis and Sappington, 1995).
Another implication of the agency theory is the potential conflict of interest between the
bondholders and the shareholders (Jensen and Meckling, 1976). Debt-holders have a priority
on claims over equity-holders. Equity-holders can either engage in riskier projects or underinvest to minimize the flow of benefits to debt-holders. Myers (1977) notes that the problem
of under-investment is particularly stronger for growth companies as it will cause them to
pass on valuable investment opportunities. Such firms are better off under equity financing.

However, Grossman and Hart (1988) suggest that the problem of under-investment can be
overcome by the use of short term debt. Short term debt can help align the interests of the
shareholders and the management.
D. The Signaling Theory
This theory attempts to address the problem of under-investment caused by information
asymmetries through the choice of capital structure. Ross (1977) develops a model to show
that information can be transferred and firm value can be signalled to the outside investors by
considering various financing alternatives. He argues that that higher leverage signals higher
quality earnings and future cash flows to investors. By increasing debt levels, firms are in
effect implicitly stating that they would be able to meet the additional debt obligation
(increased interest expense) vis-a-vis higher future profitability and cash flows. Hence, firms
may commit to higher debt levels to signal their future expectations to the market.
However, the question arises that how do firms choose their capital structure? (Myers,
1984). Certain firm-specific characteristics that determine the capital structure of firms have
come to light. These test the theories developed over the years that focus on agency costs,
information asymmetry and tax benefits particularly. Titman and Wessels (1988) identify the
following characteristics that can impact the financing behaviour of firms: asset structure,
non-debt tax shields, growth opportunities, uniqueness, industry classification, size, earnings
volatility and profitability.
The hypothesized relationships between these firm-specific characteristics and leverage are
based on groundings in theory. In part E, I first briefly discuss the theories surrounding the
determinants proposed by Titman and Wessels (1988), followed by a detailed theoretical
framework of my variables of interest which are firm size, asset tangibility, profitability,
growth and earnings volatility. Four of these factors, namely firm size, asset tangibility,
profitability and growth have been identified by Rajan and Zingales (1995) and Frank and
Goyal (2007) as being the most reliable determinants2. However, these have been found to be
consistent factors for public firms only. Some initial studies on private sector by Deloof and
Verschueren (1998) and Schoubben and Hulle (2004) find a significant relationship between
earnings volatility and leverage. Some other factors such as equity risk premium and share
Frank and Goyal (2007) also find industry mean leverage to be a reliable determinant of capital
structure. However, I exclude this from my analysis as I introduce industry fixed effects in my analysis
to control for inherent variation across industries.
2

price performance have also been used as determinants of capital structure. However, these
can only be studied for public firms. I, therefore, limit my study to the aforementioned five
firm-specific characteristics. In part F, I draw references to the fundamental differences
between public and private firms and how these differences may lead to differences in
funding behaviour. In part G, I discuss certain institutional factors that may contribute to the
differences in leverage across countries.
E. Determinants of Leverage
E.1. Overview
Myers and Majluf (1984) propose a positive relation between the collateral value of assets
and leverage. They argue that firms may be better-off selling secured debt as means to reduce
information asymmetries. According to DeAnglo and Masulis (1980), firms having large
non-debt tax shields will have a reduced incentive to benefit from the tax advantage of debt.
Consequently they would undertake less leverage. Firms having high amounts of debt are
likely to forego profitable investment opportunities (Myers, 1977). Therefore, firms
expecting high future growth will be motivated to issue equity to finance their projects.
Similarly, firms offering unique products face higher costs of bankruptcy in the event of
liquidation (Titman, 1988). This is due to the specialized skills and needs of the employees
and customers respectively that cannot be duplicated easily. Hence, such firms would be
expected to have lower leverage. Building onto this hypothesis, Titman (1988) argues that
manufacturing firms should have lower leverage compared to specialized industry firms.
Likewise, larger firms are able to undertake higher leverage as they tend to be more
diversified and hence, face lower bankruptcy risks (Ang, Chua and McConnell, 1982;
Warner, 1977). Firms with more volatile earnings also have less incentive to have high debt
levels due to limited tax advantage of debt (Deloof and Verschueren, 1998). Last, in line with
the Pecking Order theory, the literature suggests that profitable firms will utilize internal
funds and thus have lower leverage (Myers, 1984; Donaldson, 1961).
In their survey of European firms, Bancel and Mittoo (2011) find that that financial
flexibility, credit ratings and tax advantages of debt are the most important factors shaping
the debt policy of firms. Moreover, the level of interest rates and share price are considered in
timing the debt and equity issues. An enormous amount of literature has been devoted to

empirically test the determinants of capital structure. The results suggest significant
departures from theory in practice.
Titman and Wessels (1988) find that uniqueness and profitability of firms are negatively
related to the debt levels. However, they find no evidence between the relationship of
leverage and firms expected growth, non-debt tax shields, collateral value of assets and
earnings volatility. On the other hand, Harris and Raviv (1991) perform a survey and find that
leverage is positively correlated to firm size, asset tangibility, non-debt tax shields and
investment opportunities but negatively related to bankruptcy risk and uniqueness. Rajan and
Zingales (1995) report that leverage is positively correlated with size and asset tangibility but
negatively correlated with profitability and growth. A summary of some of the earlier
empirical studies conducted on public and private firms are provided in the following tables.

Table 1
Relationship between Leverage and its Determinants in prior Empirical Studies on Public Firms
Study
Sample
Period
Country
Relationship between Leverage and Firm-Characteristics
Size
Titman and
1974-
Wessels (1988)
1982
Rajan and
1987-
Zingales (1995)
1991
Frank and Goyal
1971-
(2001)
1993
Antoniou, Guney
and Paudyal
(2008)
19872000
Tangibility
Growth
Profitability
Earnings
Effective
Dividend
Non-debt Tax
Share Price
volatility
Tax Rate
Payout
Shields
Performance
Term
Structure of
Interest
Equity
Premium
USA
NS
NS
NS
NS
G-7
USA
G-5
NS
NS
X: Not Applicable
NS: Not siginificant
All other hypothesized relationships are significant

Table 2
Relationship between Leverage and its Determinants in prior Empirical Studies on Public and Private Firms
Study
Shuetrim, Lowe and Morling
Sample Period
Country
Relationship between Leverage and Firm-Characteristics

Size
Tangibility
Growth
Profitability
Earnings volatility
1973-1991
Australia
Deloof and Verschueren (1998)
1992-1994
Belgium
Schoubben and Hulle (2004)
1992-2002
Belgium
Brav (2009)
1993-2002
UK
(1993)
X: Not Applicable
NS: Not siginificant
All other hypothesized relationships are significant
10

The above tables give an insight into the capital structure determinants of public and private
firms. Empirical research suggests that firm size and tangibility are overall positively
correlated with leverage. Profitability appears to be negatively correlated with leverage across
public and private firms. However, leverage tends to differ amongst public and private firms
with respect to growth opportunities. While public firms have a negative relation with
leverage, private firms appear to have a negative relation. This could be due to the inability of
private firms to generate sufficient internal funds to fund their operations relative to the public
counterparts. They may therefore, tap the debt markets to raise funds.
Below, the theories behind the observed relationships between leverage and firm-specific
characteristics are provided.
E.2. Size
Ang et al. (1982) suggest that there is an inverse relation between bankruptcy costs as a
portion of firm value and firm value itself. They state that direct bankruptcy costs appear to
constitute a larger proportion of firm value as that value decreases. Also, it appears that
larger firms face lower bankruptcy costs as they tend to be more diversified (Titman and
Wessels, 1988). Hence, in line with the trade-off theory, larger firms may be more levered as
they have lower costs of financial distress. Rajan and Zingales (1995) report leverage to be
positively correlated to firm size for all G-7 countries except Germany which shows a
negative relationship. Deloof and Verschueren (1998) also conclude size to be positively
reported to leverage but this relationship does not hold when considering short-term debt only.
However, some other studies have also shown that due to higher information asymmetries, the
cost of issuing equity for small firms is relatively high (Smith, 1977). Rajan and Zingales
(1995) suggest that information asymmetry between the inside managers and external capital
markets is less in larger firms. Thus the cost of equity should correspondingly be lower for
larger firms and hence a preferred medium of financing. Issuance costs maybe another
consideration when deciding between different sources of external capital. These costs may be
a major deterrent for small firms to tap equity markets (Schoubben and Hulle, 2004). They
may therefore issue debt to reduce these issuance costs. The latter two theories predict a
negative relationship between size and leverage.
11

E.3. Asset Tangibility

The type of assets owned by a firm may motivate the financing behaviour of firms. Myers and
Majluf (1984) propose a positive relation between the collateral value of assets and leverage.
They argue that firms may be better-off selling secured debt as means to reduce information
asymmetries. It may be more costly for firms to sell a security about which outside investors
have little information. Likewise, Scott (1977) has proposed that firms may increase the value
of their equity by issuing secured debt. Extending this argument, Galai and Masulis (1976)
suggest that if debt is collateralized, borrowers are constrained to use the funds for a specific
project only. Since no such restriction can be enforced in the case of unsecured debt, lenders
may negotiate more costly terms of debt financing. This may lead firms to issue equity rather
than debt. Rajan and Zingales (1995) suggest that the collateral value of assets should serve to
reduce the agency costs of debt and equity such as risk shifting. Lenders would thus be more
willing to provide credit to firms having high asset tangibility.
On the contrary, Grossman and Hart (1982) propose leverage to be negatively correlated with
asset tangibility in line with the agency theory. Higher levels of debt can be undertaken to
align the interests of the managers and the shareholders. Higher leverage would induce higher
bankruptcy costs and thus limit the expropriation of private benefits by managers. Grossman
and Hart (1982) argue that agency costs maybe higher for firms having lower collateralizable
assets as it is more difficult to monitor the capital outlay of such firms. It may thus be the case
that firms with low collateral value of assets may be more levered in an attempt to discipline
managers. Previous empirical studies, such as Rajan and Zingales (1995) and Harris and
Raviv (1991), have generally reported a positive relationship between asset tangibility and
leverage.
E.4. Growth
The relationship between growth and leverage is ambiguous. Financing firm operations
through debt commits the firms to service the debt. On one hand, growth firms may avoid
taking debt as it may lead them to pass on profitable investment opportunities due to debt
servicing (Myers, 1977). Titman and Wessels (1988) note that growth opportunities are
capital assets that add value to a firm but cannot be collateralized and do not generate current
taxable income. Hence, this suggests a negative relationship between debt and growth
opportunities consistent with the aforementioned theories. On the other hand, growth firms
12

may be in need of capital, beyond internal financing, to fund their investments. Hence, they
may be more likely to tap the debt market rather than equity markets as hypothesized by
Myers and Majlufs Pecking Order theory (1984). Deloof and Verschueren (1998) find a
positive relationship between leverage and growth.
Galai and Masulis (1976) and Jensen and Meckling (1976) have modelled that shareholders of
levered firms have an incentive to invest sub-optimally to divert wealth from bondholders.
They find that this agency problem is more pronounced for growth firms that have
significantly large investment opportunities. In order to avoid the sub-optimal investment,
firms in growing industries would prefer to use equity financing over debt financing. Myers
(1984) suggests that this agency problem can be mitigated through the issue of short term debt
rather than long term debt and Green (1984) suggests the use of convertible debt.
Rajan and Zingales (1995) find a negative relation between growth and leverage. However,
they suggest that this negative relationship could also be due to firms timing their equity issue
when their stock prices are high. This temporarily causes leverage to be lower. Alternatively,
Fama and French (1992) argue that high leverage induces high costs of financial distress. The
market tends to discount the shares of firms in financial distress at a higher rate thus leading
to the above stated negative relation.
E.5. Profitability
The relationship between profitability and leverage is the most critical means of testing the
Pecking Order theory proposed by Myers and Majluf (1984). According to this theory, firms
follow a financing hierarchy. In an environment characterized by information asymmetry, it is
costly to issue a security about which outside investors have little information. Thus, internal
financing is the cheapest means of funding projects. As debt-holders have a higher claim on
firm assets as compared to equity-holders and they receive regular streams of interest
payments, debt suffers less from information asymmetry as compared to equity. Hence in
deciding the sources of financing, firms will prefer internal funds to debt and debt to equity.
The Pecking Order theory suggests that profitable firms will have lower leverage as they will
primarily meet their financing needs through retained earnings. Also, cash flow rich firms
may suffer from the agency problems of free cash flows as proposed by Jensen (1986).
Managers may expropriate private benefits creating a conflict of interest between the
managers and the shareholders. Leverage may thereby be increased to discipline the managers
13

and limit their consumption or perquisites. This predicts a negative relationship between
leverage and profitability.
However, it may be the case that lenders may be more willing to lend to profitable firms. If
so, more profitable firms would have greater access to debt markets. Moreover, profitable
firms would more likely be able to benefit from greater tax advantages of debt. This might
induce them to be more levered as dictated by the Trade-off theory. Also, Schoubben and
Hulle (2004) suggest that profitable firms may be less inclined to take debt in an attempt to
reinstate their profitability as a signal of high quality. Titman and Wessels (1988) and Rajan
and Zingales (1995) report a negative relationship between leverage and profitability.
E.6. Earnings Volatility
Volatility of earnings is a proxy for firm risk. The riskier the firm, the higher are the costs of
financial distress and greater is the probability of default. The Trade-off theory predicts that
riskier firms would then be less levered due to high bankruptcy costs. Also, firms having
volatile earnings may not be able to fully benefit from the tax advantage of debt. Similarly,
Titman and Wessels (1988) state optimal debt level to be a decreasing function of earnings
volatility. Deloof and Verschueren (1998) report a negative relationship between earnings
volatility and leverage.
Schoubben and Hulle (2004) argue that as risk of a firm increases, the cost of debt increases
simultaneously. Creditors incorporate the cost of bankruptcy in their debt contracts to protect
themselves. This causes the cost of debt to increase. Hence, in line with the Pecking order
theory and the general higher cost of debt, risky firms should rely on internal funds rather than
debt. This suggests a negative relation between leverage and a firms earnings volatility.
However, they argue that the impact of asymmetric information is heightened in riskier firms.
There is thus a need for quality signalling and discipline (Schoubben and Hulle, 2004). As
per the capital structure theories, this would imply a positive relationship between the two.
F. Differences in Capital Structure of Public and Private Firms
Public and private firms differ primarily in their listing status, ownership concentration and
information asymmetry. Public firms are listed on a stock exchange, usually have a diversified
shareholder base and are legally required to disseminate detailed information to their
shareholders through quarterly and annual reports. On the other hand, private firms are
14

unlisted, usually have concentrated ownership and are not required to make detailed financial
disclosures.
F.1. Access to Capital Markets
Public firms can issue capital to the general public whereas private firms cannot approach the
general public for capital as they are not listed on an exchange. Consequently, public firms
have a greater access to capital markets than their private counterparts. Brav (2009)
categorizes the predictions offered by the theories of capital structure into two effects, namely
the level effect and the sensitivity effect. According to the level effect, he argues that the level
of debt ratios of private firms is higher than the public firm debt ratios due to high costs of
equity of private firms relative to the cost of debt. As per the sensitivity effect, he states that
due to the overall higher costs of tapping the capital markets, private firms are likely to
exhibit passive financial behaviour. His study finds strong support for these effects. A similar
study done by Faulkender and Petersen (2006) on public firms shows that firms which have
greater access to debt markets (as proxied by a credit rating) have a greater ability to borrow
and hence, have higher leverage.
F.2. Information Asymmetry
Similarly, the degree of information asymmetry can also influence the financing behaviour of
firms. Private firms are more opaque than public firms as they are not required to make
detailed disclosures about their financial position. Outside investors only have limited
information available to assess the financial health of private companies. As equity has a
secondary claim on the firms cash flows as compared to debt, it is more sensitive to
information asymmetry (Myers and Majluf, 1984). Investors would, thus, require a higher
return to compensate from this additional risk of opacity. Noe (1988) notes that due to the
lack of transparency, the cost of equity is much higher for private firms than public firms.
Also, the cost of equity relative to debt is higher for private firms (Brav, 2009). Hence, private
firms would prefer debt to equity financing.
F.3. Ownership Concentration
As aforementioned, private firms have high ownership concentration. On the contrary, public
firms have a diversified shareholder base. Thus, control is highly valuable for equity share
15

blockholders of unquoted firms. This has two important implications for the cost of equity of
private firms relative to public equity.
First, as Stulz (1990) points out that a majority shareholder would be unwilling to resort to
equity financing if it would potentially result in a dilution of his shareholding and thus, his
control. Hence, the cost of giving away this control (cost of equity) is higher for private firms
(Amihud et al., 1990). The existing majority shareholders would require a greater
compensation to transfer their control. Also, the new shareholders would not only be paying
for a residual claim on the firms cash flows but will also pay for the value of control. As,
public firms have diluted ownership, the value of control is almost non-existent.
Second, as minority shareholders of private firms do not have the same protection and
disclosure as under public firms, equity of private firms is riskier for a minority shareholder
(Brav, 2009). He would thus require a higher return to compensate him for this additional risk
factor in order to purchase it.
There is a third dimension added to this argument by Morrellec (2004). He argues that due to
a more prominent separation between the management and the ownership in public firms, the
managers of a public firm may use equity as a means to dilute the ownership of any single
large shareholder. This implies that equity becomes a preferred means of financing for public
firms as compared to private firms.
G. Institutional Factors
Differences in leverage across countries can be attributable to differences in institutional
factors. Countries are broadly characterized as belonging to two distinct legal traditions
namely the common law regime and the civil (code) law regime. The English common law is
the most dominant legal origin of the common law regimes. The civil law regime has various
legal origins which include the Germanic code, the French code and the Scandinavian code.
The legal environment of each country is determined by first and foremost the prevalent legal
tradition and second by the legal origin to which they belong. Investor protection is then a
function of these two factors. My sample countries are ideal for studying these institutional
differences. The UK belongs to the English common law regime whereas Germany and the
Netherlands are characterized by the Germanic code law and the French code law
respectively.
16

Each of these three legal origins has distinct laws which provide for the protection of
investors. Such laws and the degree of enforcement of these laws might dictate the financing
behaviour of firms. La Porta et al. (1997, 1998) make an attempt to extensively investigate the
impact of legal origins on certain firm specific characteristics such as ownership
concentration. They provide an index measuring the degree of investor protection (creditors
and shareholders) based on different enacted laws such as bankruptcy laws, shareholder
activism laws and so on3. The index calculated by them rates creditor and shareholder
protection on a scale of 0 to 4 and 0 to 6 respectively, 4 and 6 being the most highly protected
environment.
The UK is reported to have a creditor rights rating of 4, whereas it is 3 and 2 for Germany and
the Netherlands respectively. Due to stronger creditor protection in the UK, one might expect
UK firms to have higher leverage as creditors will be willing to lend on favourable terms.
Similarly, shareholder rights, as proxied by the anti-director rights, are highest for the UK (5)
and lowest for Germany (1) whereas the Netherlands is midway at a rating of two. Also, La
Porta et al. (1998) report a highly efficient judicial system in all three countries implying a
high degree of enforcement. These measures seem to suggest that investors overall are most
highly protected in the UK. Low shareholder protection and relatively high creditor protection
in the Germany might make debt a preferred medium of financing for firms as cost of equity
might be very high.
Similarly, poor outside shareholder protection in Germany and the Netherlands suggests why
firms in these countries are closely held whereas UK firms have dispersed ownership. Also,
the relatively high ownership concentration in Germany may very well suggest that firms in
Germany on average have higher leverage as shareholders may not be willing to dilute their
control by issuing equity.
Some prior studies on capital structure have identified cross-country differences in leverage.
Rajan and Zingales (1995) find that countries with similar capital markets, such as the UK and
the United States, have very different leverage. Hence, other institutional factors such as tax
laws and bankruptcy laws are important considerations. Antoniou et al. (2008) find that
leverage across countries differ significantly. They further conclude that ownership
For a greater explanation of the index creation, please refer to La Porta, Rafael; Florencio Lopez-de-Silanes;
Andrei Shleifer; and Robert W. Vishny, 1998, Law and Finance, Journal of Political Economy 106, 11131155.
17

concentration and leverage are positively related. This is in line with the agency theory
whereby closely held firms would prefer debt over equity to avoid dilution of their control.
Creditor rights and leverage are also found to be positively related as higher protection of
creditors reduces the cost of debt and makes debt a favourable financing medium. However,
they also report a positive relation between debt and shareholder protection. They argue that
higher shareholder protection reduces information asymmetry and thereby increases debt
capacity. Overall, it can be seen that significant differences in leverage are seen to persist
across countries.
III.
Hypothesis Development
In line with the theoretical framework and prior empirical investigations, I develop my
hypotheses.
Consistent with the trade-off theory, I expect size and leverage to be positively correlated.
Private firms by nature suffer from high information asymmetries. Hence, large private firms
should have the ability to have more debt due to lower bankruptcy costs and greater access to
capital markets than small private ones.
H1a: Larger firms are likely to have higher leverage, ceteris paribus.
Firms may decrease their cost of debt by issuing secured debt. Alternatively, lenders may also
be more willing to provide credit to firms that have a high collateral value of assets. Hence,
firms having higher asset tangibility should have more access to debt markets.
H1b: Firms with higher asset tangibility are likely to have higher leverage, ceteris paribus.
Theory supports a negative relation between firm leverage and growth opportunities as higher
costs of external capital may cause firms to pass up profitable investments. However, majority
of the prior empirical studies on public firms have shown a positive relationship between
these variables. This can be due to limited internal funds to finance the growth opportunities
and hence a reliance on debt rather than equity in line with the Pecking Order theory. Hence, I
expect to find a positive correlation between leverage and growth.
H1c: Firms with higher growth are likely to have higher leverage, ceteris paribus.
18

In line with the Pecking Order theory and prior empirical findings, I expect private firms
having sufficient retained earnings to be less levered. I expect the more profitable firms to
utilize internal funds before tapping the external market.
H1d: Firms having high profitability are more likely to have lower leverage, all else equal.
Higher earnings volatility may reduce the tax benefit incentive of private firms. Also, riskier
private firms may be more reluctant to finance using debt due to higher costs of bankruptcy.
H1e: Firms having higher earnings volatility more likely to have lower leverage, ceteris
paribus.
Private firms have limited access to capital markets relative to public firms. Hence, it is likely
that they tap the external markets less frequently. In the event of raising external capital, the
cost of issuing equity for private firms is much higher relative to, both, debt and public equity.
Hence, when faced with financing decisions, private firms are more likely to resort to debt
compared to public firms, leading to higher leverage ratios.
H2: Private firms are likely to have relatively higher leverage than public firms, ceteris
paribus.
IV.
Data
A. Sources
I use the Amadeus database, managed by the Bureau van Dijk (BvD) to collect financial
statement information (balance sheet, income statement and cash flow statement items) of
private and public companies in the UK, Germany and the Netherlands for the period 20032011. BvD only covers consolidated statements for up to a maximum of ten years for any
firm. Data for an active firm therefore is available till 2002 at the latest, whereas it may go
beyond for an inactive firm. Therefore, I restrict my study to the period 2003-2011 to avoid
any selection bias. As aforementioned, my choice of the three countries is motivated by their
developed financial markets and their different legal traditions. The UK is defined by the
English legal origin, Germany by the Germanic legal origin and the Netherlands by the
French legal origin.
19

Amadeus is a comprehensive database containing financial information for over 19 million

public and private companies across forty-one countries in Europe. It focuses specifically on
private firms and hence, is an ideal source for my research. In fact, the strength of the
database lies in its extensive coverage of private firms which otherwise offer very little
information to the general public. Moreover, it represents data in a standard format which is
easy to compare and understand.
Bureau van Dijk partners with various information
providers to collect, process and deliver authentic and updated information products. In
addition to this, Amadeus particularly combines news and information from various sources
such as Financial Times, Reuters and original annual/interim reports of companies.
In addition to the financial data, I require information regarding the listing status of the firms
under study. Though this is provided by the Amadeus database, the variable reported only
represents the status of the firm as of the latest fiscal year. Since my study spans a period of
ten years, there is a likelihood that some firms in the sample were taken private while some
had an initial public offering (IPO). Hence, I make use of the Zephyr database, also managed
by the BvD, to complement the data extracted from Amadeus. The Zephyr database, like
Amadeus, contains extensive coverage deal information related to Mergers and Acquisitions,
Initial Public Offerings, Private Equity and Venture capital deals. Moreover, as both these
databases are managed by BvD, I can easily merge the datasets using the unique BvD
identification code for each company. I identify all take private and IPO deals within the three
countries and merge it with my original data set.
B. Sample
My sample includes all the incorporated entities in the UK, Germany and the Netherlands for
the period 2003-2011. Very small firms often have missing data as they are not required to
furbish an income statement. Hence, these firms are automatically excluded from the analysis.
I follow certain criteria to restrict my sample to obtain robust findings.
First, I screen firms on the basis of the type of accounts they prepare and report. Rajan and
Zingales (1995) duly notify that firms with unconsolidated balance sheets tend to understate
leverage as compared to comparable firms that provide consolidated statements. The reasons
for this are two-fold.
20

(i)
Firms having unconsolidated balance sheets report an affiliates net assets as long
term investments resulting in a higher asset base.
(ii)
These firms may report lower debt on the balance sheet via inter-firm credit
transactions conducted with an affiliate.
In line with these arguments put forth by Rajan and Zingales (1995), I only include firms
reporting consolidated financial statements to avoid inconsistencies in the analysis.
Second, I exclude firms belonging to certain industries as identified by the first two digits of
their Nace-Rev 2 Code. Brav (2009) identifies certain industries whose capital structure is
regulated and have an entirely different scope and nature of operations. These firms include
the financial sector firms (Nace-Rev 2: 64-66), public sector firms (Nace-Rev 2: 84) and
public utilities (Nace-Rev 2: 35-39).
Third, I follow the approach used by Brav (2009) in his analysis on private firms. According
to this approach, I include only the following types of firms: Private/Public Limited Liability,
Public Not Quoted, Public Quoted, Public Quoted OFEX (Off-Exchange) and Public AIM
(Alternative Investment Management) as the theories of capital structure are based on limited
liability companies. My analysis excludes Guarantee, Limited Liability Partnership, Public
Investment Trust and Unlimited firms.
Last, I identify firms that went public via an IPO or were taken private during the study
period. For a firm that underwent an IPO, I define the status of the firm as private pre-IPO and
public thereafter. Similarly, with the take private deals, I earmark the firm as being public
before the deal year and private thereafter.
After screening my dataset on these criteria, my sample consists of a total of 14,863 firms of
which 5,598 are public and 9,265 are private, 17 IPO deals and 10 take-private deals as shown
in Table 3 below.
Table 3
Sample Statistics
Germany
Netherlands
United Kingdom
All
Public firms
54
112
877
5,598
Private firms
802
4,667
8,351
9,265
All firms
856
4,779
9,228
14,863
21

C. Research Methodology
I follow the methodology used by Brav (2009) in his empirical study on the funding behavior
of public and private firms in the UK. Following this methodology, I employ a pooled panel
ordinary least squares (OLS) regression model to study the correlation between the different
hypothesized determinants of capital structure namely, firm size, asset tangibility,
profitability, growth and earnings volatility with leverage.
Panel data has the advantage over other forms of data in that it can yield robust results for a
relatively short time series across several different observations in a cross-section. Hsiao
(1985) states that a panel data offers a large set of data points which reduces the collinearity
among explanatory variables and produces efficient coefficients. I interact my independent
variables with the status of the firm whereby Public takes the value of 1 if the firm is quoted
and 0 otherwise and Private takes the value of 1 of the firm is unquoted and 0 otherwise.
However, I include year, country and industry fixed effects in my model. Leary and Roberts
(2005) model initial leverage in their analysis and conclude that firms tend to revert to a mean
long run optimal leverage in the long run. Hence, I control for this by using year fixed effects.
Similarly, as my study spans across three countries, I introduce the country fixed effects to
cater to the institutional differences between the countries. Rajan and Zingales (2005) states
the importance of considering institutional factors especially in terms of bankruptcy laws and
market orientation. Germany and the Netherlands are bank-oriented whereas UK is a marketoriented economy. Antoniou et al. (2008) argue that firms leverage ratio is crucially
influenced by the role of capital markets, investor protection, tax systems and corporate
governance practices. Hence, these differences need to be controlled for. Likewise, leverage
can vary across industries whereby manufacturing firms tend to be more highly levered
(Titman and Wessels, 1988). Frank and Goyal (2007) find leverage to be significantly related
to industry classification. Hence, I introduce industry fixed effects. The equation to be
estimated is as follows:
Leverage(i,t) = 0 + (i)`X(i,t-1) + Country Fixed Effect + Industry Fixed Effect +
Year Fixed Effect + i,t
where,
X(i,t) is a matrix of independent variables interacted with the firm status to provide a pooled
data. In order to avoid any endogeneity problems, I lag my independent variables one year.
22

D. Variable Measurement
Before defining my variables, I first make an adjustment to balance sheet data to make
consistent comparisons as is done by Rajan and Zingales (1995). They argue that German
liabilities are largely composed of dubious provisions which are in reality equity components.
I, therefore, reclassify provisions as shareholders equity across all countries.
My dependant variable is leverage. Theory provides several measures of leverage. Such
measures include total liabilities to total assets, total debt (short-term debt plus long-term
debt) to total assets, total debt to total capital. From the perspective of solvency, yet another
measure of leverage can also be the interest coverage ratio. However, all these measures have
their own shortcomings as elaborated by Rajan and Zingales (1995) in their study of capital
structure. The ratio total liabilities to total assets provides a measure of the shareholders
residual interest. However, this ratio includes items such as trade credits and pension
liabilities which do not represent financing activities and hence leverage may be overstated.
Also, this ratio is not a good indicator of default risk. This leads to the second measure of
leverage defined as the ratio of total debt to total assets. This measure, however, does not take
account for the fact that certain assets and non-debt liabilities may act contra to each other. An
example is of accounts payable and accounts receivable which may jointly be affected by
industry considerations. One might then revert to a measure of total debt to net assets whereby
net assets are given by total assets less accounts payable and other liabilities. However, this
ratio may also be affected by non-financing factors such as pension assets. The ratio debt to
capital seems appropriate as it reflects the proportion of firm capital financed through debt.
However, there is a limitation with this measure as well. A firm might be faced with negative
equity due to write-offs pertaining to currency depreciation, impairments or leveraged
buyouts. Since these are non- firm specific characteristics, this measure might not be suitable
for analysis of this study. Similarly, the interest coverage ratio is a flow measure and very
sensitive to fluctuations in net income. The following table gives an overview of these
different measures of leverage for each country as well as for the entire sample.
23

Table 4
Different measures of Leverage for the entire sample of Public and Private Firms and the subsample of firms in each country. The Difference statistic reports the difference in
the respective leverage measure between quoted and unquoted firms. *, **, *** denote significance at the 10%, 5% and 1% level respectively.
Germany
Netherlands
United Kingdom
All
Public
Private
Difference
Public
Private
Difference
Public
Private
Difference
Public
Private
Difference
Mean
0.275
0.303
-0.028***
0.148
0.055
0.094***
0.203
0.329
-0.126***
0.196
0.223
-0.027***
Median
0.206
0.280
0.093
0.000
0.163
0.258
0.158
0.116
60
3332
839
25601
5215
38389
6114
67322
Mean
0.357
0.390
0.188
0.073
0.250
0.401
0.242
0.275
Median
0.266
0.382
0.130
0.000
0.204
0.335
0.198
0.156
60
3308
839
25600
5209
38154
6108
67062
Mean
0.533
0.543
0.524
0.607
0.520
0.664
0.521
0.637
Median
0.529
0.553
0.523
0.624
0.501
0.662
0.504
0.639
61
3645
710
23278
5157
38581
5928
65504
Mean
0.441
0.476
0.239
0.106
0.338
0.516
0.325
0.359
Median
0.276
0.477
0.197
0.000
0.262
0.439
0.256
0.232
60
3332
837
25313
5215
38378
6112
67023
Mean
5.070
8.961
7.757
11.244
7.225
7.185
7.262
7.816
Median
1.163
3.806
4.208
4.503
3.391
1.884
3.466
2.311
50
3417
564
5697
4616
37144
5230
46258
Debt to Total Assets
Debt to Net Assets

-0.033***
0.115***
-0.151***
-0.033***
Nonequity Liabilities to Total Assets

-0.009***
-0.083**
-0.144***
-0.116***
Debt to Total Capital

-0.034***
0.133**
-0.178***
-0.034***
Interest Coverage
-3.891***
24
-3.487***
0.040***
-0.554***

The table provides some initial evidence that private firms are more highly levered as
compared to public firms. The leverage ratios across all different measures of leverage are
significantly higher for private firms. Looking at the entire sample statistics, private firms
appear to have 22.3% debt to total assets and 35.9% debt to total capital. The same ratio for
public firms is 19.6% and 32.1% respectively. To the contrary, the interest coverage ratio is
higher for public firms which may suggest debt levels, vis-a-vis interest payments, are lower
for public firms. This could be a consequence of a lower absolute cost of debt for public firms
that could lead to lower interest payments relative to private firms.
These findings also hold across the subsample of different countries with the exception of the
Netherlands. Private firms in the UK and Germany have higher leverage ratios as compared to
public firms. However, this is reversed for firms in the Netherlands whereby public firms
report higher leverage ratios than private firms. However, the Netherlands seems to be an
exception. Public firms in the Netherlands appear to be more highly levered than private
firms. Across the countries, German and British firms have relatively higher leverage as
compared to the Dutch firms which have the least leverage across all measures for both public
and private firms. The relatively higher leverage ratios for German and British firms can be
attributed to their Germanic and English legal origins, respectively, which offer strong
creditor protection. The Netherlands is characterized by the French legal origin which has the
weakest creditor protection and this might be the reason for relatively low debt measures.
Amongst the firms in the UK and Germany, private British firms appear to have higher
leverage than likewise private German firms (32.9% vs. 30.3% debt to total assets ratio and
51.6% vs. 47.6% debt to total capital ratio respectively). Again looking at creditor protection
metrics provided by La Porta et al. (1998), UK emerges as the strongest creditor protected
state (See Appendix, Table B). Hence, creditors may be willing to lend at more favourable
terms to private firms in the UK, resulting in higher proportion of debt as compared to
Germany.
Given the pros and cons of each measure proposed by Rajan and Zingales (1995)4, I employ
the ratio total debt to total assets as a measure of leverage because of two reasons. First, it
appears to capture the essence of my analysis to explain the proportion of debt taken by a firm
by certain firm-specific factors. Second, it is one of the most widely employed measures of
4
Please refer to the paper for an in-depth discussion on each measure of leverage (Rajan and Zingales, 1995).
25

leverage in empirical literature for example in Antoniou et al. (2008), Brav (2009), Schoubben
and Hulle (2004). Also, it is important to note that since my sample consists of private firms, I
can only make use of book leverage and not market leverage in my analysis. Previous studies
such as those undertaken by Rajan and Zingales (1995), Leary and Roberts (2005) suggest
that this is not a major limitation as results are more or less robust across both measures. To
make consistent comparisons, I use book leverage for public firms as well.
I follow the empirical literature to define my independent variables. Firm size is given by the
natural logarithm of turnover, tangibility by the natural logarithm of tangible assets,
profitability as the ratio of operating income to total assets (return on assets), growth as the
growth in sales and earnings volatility as the three-year standard deviation in return on assets.
The measure of earnings volatility causes me to lose the first two years of my data. Also, as I
lag my variables by one year, this results in an analysis period of 2005-2011. I winsorize all
my variables at the 0.5% level at each tail to eliminate the problem of outliers. Moreover,
since leverage cannot be negative, I further eliminate observations reporting a negative
leverage due to data errors.
E. Descriptive Statistics
Table 5 and Table 6 provide the summary statistics for the entire sample and the subsample
pertaining to each country respectively. The tables report the statistics for public and private
firms separately along with their means and medians.
Again, as can be seen in Table 5, private firms have higher leverage as compared to public
firms. Public firms have an average of 22.3% debt as a proportion of total assets whereas the
same mean ratio is only 19.6% of all public firms. Similarly, the average ratio of debt to total
capital for private firms is 35.9% and for public firms it stands at 32.5%. Also, an interesting
thing to note is that short-term debt constitutes 48.4% of total debt for private firms but only
41.0% for public firms. This provides additional support to two prior findings. First, it
supports the hypothesis suggested by Grossman and Hart (1988) that firms may use short term
debt alleviate the problems of information asymmetry. Second, it may be so that private firms
use short-term debt to provide liquidity to their creditors as suggested by Brav (2009). Public
firms can provide liquidity to their creditors through the issue of new shares. This option is
unavailable to private firms and hence the use of short-term debt as an alternative. Public
firms also have higher cash holdings as a proportion of total assets, 15.8% versus 12.7% for
26

private firms. This seems strange as one might as well expect private firms to have a higher
cash base for transactions and speculative purposes. Also, as public firms are more likely to
easily access capital markets, one might expect them to hold lower cash balances to optimize
working capital. However, this does not appear to be the case in my sample of firms.
Also, public firms are larger than private firms both in terms of total assets and sales.
However, the mean tangibility of private firms is higher than that of public firms suggesting
that public firms on average have higher intangible assets. Mean growth of public firms is
higher than private firms. Higher growth prospects may in fact be one of the reasons that
firms may decide to go public to tap the equity markets. Firms having growth opportunities
may be unable to generate sufficient internal funds to finance these opportunities. Thus,
public equity may then be a viable alternative to fund growth. Private firms appear to be more
profitable on average as compared to public firms. The mean return on assets for private firms
is 4.6% whereas it is -2.5% for public firms. This might in turn also explain the high volatility
in earnings of public firms as opposed to private firms.
Looking at the subsample of each country in Table 6, the same results hold broadly. Across all
countries, public firms are larger both in terms of sales and total assets, have higher growth
prospects, higher volatility in earnings and are less profitable compared to private firms. For
firms in the UK and Germany, private firms have higher leverage than public firms. Similarly,
short-term debt constitutes a large portion of total debt for private firms, 50.0% and 33.0% for
firms in the UK and Germany respectively. However, results pertaining to debt ratios are not
consistent across Dutch firms. Dutch private firms have lower leverage than public firms.
Moreover, this debt is almost equally distributed between long-term and short-term debt. As
aforementioned, one of the reasons why private firms might have higher levels of debt is that
the cost of debt may be lower than the cost of equity, thereby making debt a more attractive
financing choice. Given the poor creditor protection provided by the Dutch legal system, this
may not hold. In order to safeguard their interests, lenders may then only be willing to lend at
a high cost to incorporate this risk. It could also be that lenders may be less willing to provide
credit to private firms which by nature have high information asymmetries. Hence, this could
be the reason why Dutch private firms have lower levels of debt compared to public firms.
Also, private firms in the Netherlands and Germany have higher cash holdings as a percentage
of total assets which is in line with the principles of working capital management which
predict that smaller firms should have higher cash holdings ceteris paribus.
27

Table 5
Summary Statistics for the entire sample of public and private firms
Summary statistics for the sample of public and private firms. The Difference statistic reports the difference in the respective leverage measure between quoted and unquoted
firms. All ratios are given in basis points. *, **, *** denote significance at the 10%, 5% and 1% level respectively.
Mean
Median
SD
Min
Max

Public
Private
Difference
0.196
0.223
-0.027***
0.158
0.116
0.198
0.275
0.00
0.00
1.164
1.184
6,114
67,322
Public
Private
Difference
0.325
0.359
-0.034***
0.256
0.232
0.387
0.442
0.00
0.00
2.591
2.962
6,112
67,023
Public
Private
Difference
0.410
0.484
-0.075***
0.301
0.441
0.354
0.365
0.00
0.00
1.000
3.814
5,242
45,629
Public
Private
Difference
0.158
0.127
0.031**
0.090
0.060
0.354
0.365
0.00
0.00
1.000
3.814
6,818
74,506
Public
Private
Difference
1,636,756
193,331
1,443,425***
73,198
22,495
8,454,098
1,418,232
10.00
0.00
221,000,000
67,600,000
6,976
77,125
Public
Private
Difference
1,305,118
214,551
1,090,567***
74,046
37,026
5,115,899
1,817,878
1,418,415
200,227
72,000,000
140,000,000
6,810
64,933
Public
Private
Difference
11.137
10.427
0.710***
11.229
10.522
2.589
1.793
4.595
4.595
15.462
15.462
6,788
64,874
Public
Private
Difference
0.208
0.111
0.096***
0.059
0.032
0.768
0.585
-0.820
-0.629
4.325
4.778
5,805
52,328
Public
Private
Difference
-0.025
0.046
-0.071***
0.050
0.051
0.252
0.157
-0.930
-0.930
0.450
0.432
6,973
75,494
Public
Private
Difference
0.199
0.281
-0.082***
0.114
0.211
0.222
0.256
0.00
0.00
0.954
0.922
6,932
75,386
Public
Private
Difference
0.083
0.049
0.034***
0.034
0.027
0.127
0.078
0.001
0.001
0.603
0.603
5,001
49,178
Short-term Debt to Total Debt
Cash to Total Assets
Total Assets ( 000)
Turnover ( 000)
Size
Growth
Profitability
Tangibility
Volatility
28

Table 6
Summary statistics of public and private firms for each Country
Summary statistics for public and private firms in each country. The Difference statistic reports the difference in the respective leverage measure between quoted and
unquoted firms. All ratios are given in basis points. *, **, *** denote significance at the 10%, 5% and 1% level respectively.
Mean
Germany
Median
Mean
Netherlands
Median
Mean
United Kingdom
Median

Public
Private
Difference
0.275
0.303
-0.028***
0.206
0.280
60
3,332
0.148
0.055
0.094***
0.093
0.00
839
25,601
0.203
0.329
-0.126***
0.163
0.258
5,215
38,389
Public
Private
Difference
0.441
0.476
-0.034***
0.276
0.477
60
3,332
0.239
0.106
0.133***
0.197
0.00
837
25,313
0.338
0.516
-0.178***
0.262
0.439
5,215
38,378
Public
Private
Difference
0.237
0.330
-0.094***
0.137
0.249
53
3,201
0.490
0.481
0.009***
0.425
0.429
573
6,233
0.402
0.499
-0.097***
0.289
0.467
4,616
36,195
Public
Private
Difference
0.099
0.103
-0.004***
0.076
0.059
61
3,638
0.070
0.050
836
26,436
0.165
0.136
0.029***
0.094
0.066
5,921
44,391
Public
Private
Difference
11,700,000
302,949
11,397,052***
102,618
82,599
61
3,647
3,030,745
192,594
2,838,151***
297,044
20,548
851
27,318
1,339,981
185,106
1,154,875***
62,509
21,391
6,064
46,160
Public
Private
Difference
6,991,723
385,634
6,606,089***
120,475
133,962
61
3,562
2,874,516
367,107
2,507,409***
377,179
63,536
840
16,626
1,023,314
144,247
879,068***
60,875
25,276
5,909
44,745
Public
Private
Difference
11.898
11.221
0.677***
11.699
11.805
61
3,562
12.495
11.141
1.353***
12.840
11.058
840
16,647
10.935
10.044
0.892***
11.029
10.141
5,887
44,665
Public
Private
Difference
0.155
0.065
0.089***
0.048
0.041
50
2,748
0.142
0.108
0.035***
0.056
0.048
725
13,099
0.218
0.116
0.102***
0.060
0.024
5,030
36,481
Public
Private
Difference
-0.077
0.088
-0.164***
0.032
0.082
61
3,575
0.045
0.078
-0.033 ***
0.065
0.068
851
26,114
-0.034
0.024
-0.058***
0.047
0.040
6,061
45,805
Public
Private
Difference
0.259
0.317
-0.058***
0.228
0.296
61
3,641
0.245
0.290
-0.045***
0.174
0.231
850
26,994
0.192
0.273
-0.081***
0.106
0.186
6,021
44,751
Public
Private
Difference
0.112
0.032
0.080***
0.026
0.022
40
2,001
0.049
0.045
0.004***
0.023
0.029
626
17,218
0.088
0.053
0.035***
0.037
0.026
4,335
29,959
Short-term Debt to Total Debt
Cash to Total Assets

0.114
0.116
-0.002
Total Assets ( 000)
Turnover ( 000)
Size
Growth
Profitability
Tangibility
Volatility
29

A univariate analysis can only at best give an initial glimpse of the data characteristics. One
cannot derive any conclusion from the results of Table 5 and 6. For, example, it can be seen
that private firms have higher leverage than public firms. However, this difference could also
be driven by other factors such as size or even profitability. As can also be seen that private
firms on average have higher profitability than public firms. Hence, it could very well be that
higher leverage may be driven by the higher profitability of private firms and not firm status.
Hence, I run a multivariate regression to conclusively test my hypotheses.
V.
Empirical Results
A. Multivariate Analysis
Table 7 shows the results of a pooled panel ordinary least squares regression for the entire
sample of public and private firms. Column A reports the results without the country fixed
effects whereas Column B includes country fixed effects. As can be seen, the status of the
firm (as proxied by the dummy variable Public) is, both economically and statistically,
significant across both specifications. Public firms have approximately 31.5% lower leverage
than private firms without the country fixed effects and 25.6% lower leverage with the
inclusion of country fixed effects, ceteris paribus.
An interesting observation is the discrepancy between the effect of size of private and public
firms on leverage. A 1% increase in firm size of public firms causes leverage to increase by
0.011%. Hence, leverage is increasing in firm size for public firms as predicted by earlier
empirical studies as well such as Rajan and Zingales (1995) and Frank and Goyal (2003). This
finding lends support to the ability of firms to borrow more as they become larger and more
diversified. Also, as firms become more diversified, the cost of bankruptcy decreases
enhancing their ability to borrow more. In terms of economic significance, a one standard
deviation increase in size of public firms would increase leverage by 14.5% on average
around the mean leverage.
However, my findings suggest a negative relation between firm size and leverage of private
firms. So as to say, as firm size increases by 1%, leverage decreases by 0.011% for the private
firm sample. Similarly, in terms of economic significance, a one standard deviation increase
in firm size would decrease leverage by 8.7% around the mean. This negative result has been
reported earlier by Rajan and Zingales (1995) for their subsample of German firms. This
30

supports two prior thoughts. First, it reinforces the hypothesis proposed by Titman and
Wessels (1988) and Schoubben and Hulle (2004) which states that larger firms have lower
equity issuance costs. Therefore, equity may be a preferred medium of financing for larger
firms. Second is the theory proposed by Smith (1977) which states that information
asymmetry and agency costs are a decreasing function of size. Hence, the cost of issuing
equity for small firms is relatively high and they may then turn to debt. These latter two
theories seem to hold for the sample of private firms. However, with the introduction of
country dummies, size of private firms becomes positively correlated with leverage. A 1%
increase in size of private firms would increase leverage by 0.002%. Hence, size becomes
positively correlated with leverage with the introduction of country fixed effects. The size
variable, though statistically significant, appears to be economically insignificant around the
mean values of leverage (19% and 22% for public and private firms respectively).
Also, growth of public firms is negatively correlated with leverage but is statistically
insignificant (not significantly different from zero) as has also been found by Titman and
Wessels (1988) in their study on capital structure. However, the growth of private firms is
positively correlated with leverage and statistically significant. This relation is in line with the
findings of Deloof and Vershueren (2004) and Brav (2009). A 1% increase in growth
prospects increases leverage of private firms by 1.7%. This shows that private firms need to
tap the external debt markets to fund their growth opportunities as internal funds may be
insufficient. Alternatively, a one standard deviation increase in growth would increase
leverage of private firms by 4.46% around the mean leverage.
Across the public and private firm sample respectively, profitability is strongly negatively
correlated with leverage whereas Asset tangibility and volatility are positively correlated with
leverage. The findings of the correlation of leverage with profitability and tangibility are in
line with the results of prior studies such as those by Rajan and Zingales (1995), Schoubben
and Hulle (2004) and Brav (2009). The positive correlation between leverage and volatility is
supported by an earlier study by Bennet and Donnelly (1993) but contradicts studies by
Schoubben and Hulle (2004) and Deloof and Vershueren (2004).
Looking at these variables separately for the subsample of public and private firms, I find that
a 1% increase in ROA (profitability measure) decreases leverage by 8.8% for public firms and
39.0% for private firms. This supports the Pecking Order theory whereby as firms become
more profitable, they utilize internal funds before approaching the external markets. Also,
31

profitable firms may use their profits to repay debt further supporting the Pecking Order
Theory. It is worth noting, the leverage of private firms is more sensitive to profitability
compared to public firms. This can be explained in terms of the cost of capital for private
firms. As profitability increases, private firms will reduce their leverage more than public
firms as the absolute cost of tapping the external market is higher for private firms. Hence,
private firms are more likely to strongly rely on internal funds, all other things staying the
same.
Similarly, with a 1% increase in tangibility, leverage increases by 0.171% and 0.111 %
respectively for public and private firms. Similarly, a one standard deviation increase in
tangibility will increase leverage by approximately 19% and 13% around the mean leverage,
for public and private firms respectively. Thus, as the ability of firms to issue secured debt
increases (in terms of asset collateral), their debt levels increase. However, for the same
increase in asset tangibility, public firms seem to borrow more as compared to private firms.
Last, a 1% increase in earnings volatility causes leverage of public firms to increase by 24.3%
whereas it is only 6.2% in case of private firms. The positive relation can be explained by the
reasoning of Bennett and Donnelly (1993). They argue that as the risk of a firm increases, the
agency costs pertaining to asymmetric information increase as well. Increasing debt levels
would be a way to signal quality earnings. In terms of economic significance, a one standard
deviation increase in earnings volatility would increase leverage by 15.7% and 2.1% around
the mean leverage for public and private firms respectively.
The traditional determinants of leverage appear to be both statistically and economically
significant across both the private and public firm subsample (with the exception of growth of
public firms). It can be seen that leverage of private firms is less sensitive to asset tangibility
and volatility. This is again attributable to the differential cost of external capital for public
and private firms. As it is more costly for private firms to raise external capital, they will be
more reluctant to increase their leverage with an increase in debt capacity. Moreover, I
employ a difference of means test to test whether the mean of variable X for private firms
equals the mean of variable X for public firms whereby variable X is each of the independent
variables. The p-values of the test are reported in Panel B of Table 7. The results show that
each of the variables for public firms are significantly different from their private
counterparts.
32

Table 7
Determinants of Leverage
Panel A shows the results from a pooled panel OLS regression. The t-statistics of the regression are reported in
the brackets and are corrected for heteroskedasticity. The dependent variable is given by the ratio of debt to total
assets.I interact each of my independent variables with the status of the firm. Public and Private are dummy
variables with Public taking the value of 1 (0) if the firm is quoted (unquoted) and Private taking the value 1 (0)
if the firm is unquoted (quoted). Column 1 reports the results without the country fixed effects. Column 2 reports
the regression results with the inclusion of country dummies. The definitions of the independent variables are
provided in the Appendix. Panel B reports the p-values of the test of differences whereby I test whether Private
X = Public X, X being each of the independent variables. *, **, *** denote significance at the 10%, 5% and 1%
level respectively.
Panel A
Leverage
-0.315***
(-15.01)
0.011***
(7.62)
-0.011***
(-12.02)
-0.002
(-0.34)
0.017***
(4.30)
-0.088***
(-3.63)
-0.390***
(-25.02)
0.171***
(11.43)
0.111***
(16.79)
0.243***
(5.2)
0.062*
(1.74)
Public
Public Size
Private Size
Public Growth
Private Growth
Public Profitability
Private Profitability
Public Tangibility
Private Tangibility
Public Volatility
Private Volatility
Leverage
-0.256***
(-12.48)
0.016***
(11.41)
0.002**
(2.14)
-0.001
(-0.13)
0.018***
(4.97)
-0.099***
(-4.23)
-0.333***
(-22.5)
0.176***
(11.79)
0.114***
(18.72)
0.235***
(5.2)
0.166***
(5.01)
0.023***
(3.93)
-0.204***
(-83.41)
0.241
17.9
Yes
Yes
Yes
0.215
40601
Germany
Netherlands
Constant
Country Fixed Effects
Time Fixed Effects
Industry Fixed Effects
Adjusted R-squared
Number of Observations
0.325
23.32
No
Yes
Yes
0.109
40601
Size
Growth
Profitability
Tangibility
Volatility
0.000***
0.000***
0.000***
0.000***
0.000***
Panel B
0.000***
0.000***
0.000***
0.000***
0.000***
Similar results hold in Column B with the specification of country fixed effects added to the
original regression equation. However, an interesting finding is the coefficients for the
country dummies in Column B. These coefficients are highly significant. They show that
leverage of firms in the Netherlands is approximately 20% lower than the leverage of firms in
the UK. Similarly, German firms on have around 2.3% higher leverage than firms in the UK.
This finding suggests that country-specific factors other than the traditional hypothesized
variables (size, growth, profitability, tangibility and volatility) are also important determinants
33

of leverage. Institutional laws such as shareholder and creditor protection rights may explain
why leverage in one country is higher or lower. In order to understand these differences, I
repeat the multivariate regression above for each of the sample countries separately. The
results are reported in Table 8.
B. Cross-Country Analysis
Looking at the country subsample, the coefficient of the public status loses its significance for
the German firms suggesting that leverage of private firms is not statistically different from
the leverage of public firms. Moreover, it is positive for the Dutch firms, which suggests that
the leverage of public firms is 8.8% higher than the leverage of private firms. As discussed in
the summary statistics, one reason for this could be the poor creditor protection rights in the
Dutch legal system which deters lenders to easily lend to private firms as private firms
inherently suffer from lack of transparency and information asymmetries. However, public
firms in the UK have 23.3% lower leverage than private firms which is consistent with the
results of Table 7.
The German firms do not report any significant relationship between size and leverage for
both public and private firms. For Netherlands, public firms do not report a significant
relationship whereas private firms report a significant positive relationship. UK firms, both
public and private respectively, report a significant positive relationship suggesting that
leverage is increasing in firm size. Amongst the private firms, the leverage of Dutch firms is
more sensitive to size compared to UK firms. For the same increase in size, Dutch private
firms tend to increase their leverage more as compared to private firms in the UK.
Only public firms in Germany report a significantly negative relationship with leverage> It
shows that public firms in Germany faced with growth opportunities do not want to be
committed to servicing higher debt as it may cause them to pass up profitable investment
opportunities. Hence, they will prefer lower leverage. Similar results hold for private firms in
the Netherlands which show a negative correlation with leverage. Consistent with the findings
of Table 7, growth of private firms in Germany and UK is significantly positively correlated
to leverage. Hence, one sees opposite effects of growth of private firms on leverage in the
Netherlands and Germany and UK. Lenders may only be willing to lend credit to private
Dutch firms at a very high rate to protect themselves. This may deter private firms to opt for
34

debt to finance their growth prospects as it may be difficult for them to simultaneously service
the debt at high cost and invest.
Again, profitability is negatively correlated with leverage for both the public and private firms
across the three countries, though it is insignificant for public German firms. This lends
further support to the Pecking Order Theory. Also for all countries, leverage is more sensitive
to the profitability of private firms as compared to the public firms. Amongst the subsample of
private firms, leverage of German firms is most sensitive to profitability. For a 1% increase in
profitability of private firms, leverage of German firms decreases by 59.1% whereas it only
decreases by 19.3% and 41.3% respectively for the Dutch and British firms.
Also, tangibility is positively correlated with leverage for both public and private firms across
the three countries. However, the effect of tangibility on leverage for German public firms is
not statistically different from zero. For firms in the Netherlands and UK, leverage of public
firms is more sensitive to tangibility than the leverage of private firms. As tangibility
increases, German private firms increase leverage by most compared to other countries.
With regards to volatility, German public firms and British public and private firms show a
significantly positive correlation with leverage supporting the results of Table 7. However,
private firms in the Netherlands are characterized by a negative relationship between leverage
and volatility. As risk increases, probability of default increases and bankruptcy costs increase
making debt less desirable.
Panel B of Table 8 again reports the p-values of the test of differences of mean. As can be
seen, all variables for public firms are statistically different from their private counterparts for
each of the three countries.
35

Table 8
Panel A shows the results from a pooled panel OLS regression for the subsample of firms in each country. The tstatistics of the regression are reported in the brackets and are corrected for heteroskedasticity. The dependent
variable is given by the ratio of debt to total assets. I interact each of my independent variables with the status of
the firm. Public and Private are dummy variables with Public taking the value of 1 (0) if the firm is quoted
(unquoted) and Private taking the value 1 (0) if the firm is unquoted (quoted). Column 1 reports the results
without the country fixed effects. Column 2 reports the regression results with the inclusion of country dummies.
The definitions of the independent variables are provided in the Appendix. Panel B reports the p-values of the
test of differences whereby I test whether Private X = Public X, X being each of the independent variables. *, **,
*** denote significance at the 10%, 5% and 1% level respectively.
Panel A
Leverage
Netherlands
Germany
Public
United Kingdom
Time Fixed Effects

Adjusted R-squared
0.118
(0.45)
-0.012
(-0.58)
-0.003
(-0.74)
-0.133***
(-2.35)
0.085***
(3.89)
-0.054
(-0.26)
-0.591***
(-10.87)
0.214
(1.36)
0.385***
(14.77)
0.037***
(2.71)
-0.087
(-0.67)
0.28
(4.51)
Yes
Yes
0.234
1920
0.088**
(1.96)
0.002
(0.72)
0.007***
(6.69)
0.016
(1.46)
-0.007**
(-1.96)
-0.123***
(-2.66)
-0.193***
(-7.07)
0.190***
(6.61)
0.072***
(10.37)
-0.047
(-0.5)
-0.148***
(-5.21)
-0.059
(-3.64)
Yes
Yes
0.142
10738
Panel B
-0.233***
(-8.22)
0.014***
(6.37)
0.003***
(2.75)
-0.001
(-0.12)
0.021***
(5.88)
-0.091***
(-3.41)
-0.412***
(-29.93)
0.152***
(7.32)
0.117***
(17.13)
0.23***
(4.55)
0.227***
(8.44)
0.193
(11.57)
Yes
Yes
0.138
27943
Size
Growth
Profitability
Tangibility
Volatility
0.000***
0.000***
0.000***
0.000***
0.000***
0.000***
0.000***
0.000***
0.000***
0.000***
0.000***
0.000***
0.000***
0.000***
0.000***
Public Size
Private Size
Public Growth
Private Growth
Public Tangibility
Private Tangibility
Public Volatility
Private Volatility
Constant
C. Analysis of Variance
Having looked at cross-country differences between the traditional determinants of leverage, I
perform an Analysis of Variance (ANOVA). This breaks down the variation in leverage due
to each of the independent variables. It can be seen in column (a) that the status of the firm
explains 3.8% of the variation in leverage in our model. Similarly, size explains 6.4%, growth
1.3%, profitability 45.7%, tangibility 42.5% and volatility 0.2% variation in leverage. The
adjusted R-squared from this specification is only 6.3%. However, the adjusted R-squared
36

increases to 18.1%with the inclusion of country fixed effects (as shown in column (d)) and
21.0% with the inclusion of country, year and industry fixed effects (shown in column (h)).
Also to note in column (h) is that country dummies explain 62.5% variation in our modeled
leverage and industry fixed effects explain 16.5% of the variation in leverage. This shows the
importance of both institutional factors and industry specifications as determinants of
leverage.
Table 9
Analysis of Variance
Variance Decomposition
(a)
(b)
(c)
(d)
Public Status
0.038
0.015
0.038
0.049
0.033
Size
0.064
0.020
0.062
0.003
0.006
Growth
0.013
0.007
0.010
0.005
0.003
Profitability
0.457
0.296
0.454
0.097
0.093
Tangibility
0.425
0.145
0.422
0.131
0.062
Volatility
0.002
0.002
0.002
0.006
Industry
0.514
Year
(e)
(f)
(g)
0.007
1.000
0.012
0.169
1.000
Country
(h)
0.709
0.002
1.000
0.625
Adjusted R-Squared
0.063
0.099
0.0643
0.181
0.082
0.0002
0.210
0.210
No. of Observations
40601
40601
40601
40601
73436
73436
73436
40601
D. Institutional Differences
Having looked at the cross country differences in leverage and established the importance of
institutional factors in the determination of leverage, I directly explore the relationship
between institutional factors and leverage. For this purpose, I make use of four additional
factors in the determination of leverage, namely rule of law, ownership concentration,
shareholders rights (proxied by anti-director rights) and creditors rights as discussed by La
Porta et al. (1998). These factors capture the essence of cross country differences in terms of
different institutions. Table 10 reports the results from an OLS regression. It can be seen that
the traditional determinants of leverage retain their significance and relationship with leverage
across the sample of public and private firms. It is pertinent to mention that the rule of law
and creditor rights protection imply two different legal measures. For example, while in the
Netherlands, creditor rights are weak, rule of law is the highest. This only shows that while
the rights of the creditors are not protected very highly by law but the Dutch code law is
highly enforced.
37

The variables of interest in this table are the institutional factors. Creditor rights and
ownership concentration are positively correlated with leverage whereas anti-director rights
(also shareholder rights) and rule of law are negatively correlated with leverage across both
public and private firms. All these variables are statistically highly significant. An increase of
1 unit scale of creditor rights increases leverage by 8.3% in terms of public firms and 17.1%
in terms of private firms. The greater the rights of the creditors are protected, the more will
the creditors be willing to lend at a lower rate. In cases where the rights of creditors are not
secured by law, creditors incorporate the additional risk in their borrowing rate leading to
higher cost of debt. Hence, we see high debt levels for firms in Germany and the UK
compared to Netherlands, consistent with the degree of protection offered to creditors in these
countries respectively.
Similarly, the ownership concentration is negatively correlated with leverage. The reasoning
behind this may be taken from the discussion on public and private firms as well. The higher
the ownership concentration, the more reluctant are the current shareholders to issue equity as
it would result in a dilution of control. A 1% increase in ownership concentration will result in
a 13.4% and 22.5% increase in leverage across public and private firms respectively. German
firms have the highest ownership concentration measure. Consistent with this, German public
firms also have the highest leverage measure as discussed in Table 6. However, UK private
firms appear to have the highest leverage amongst the sample even though they have the
lowest mean percentage ownership concentration.
Also, the rule of law is negatively correlated with leverage. It should be noted that the rule of
law incorporates the enforcement of different laws, including bankruptcy laws. Hence, it may
be so that in order to avoid the stringent bankruptcy laws, firms may be reluctant to have high
debt so as to avoid bankruptcy. This appears to be true for the Netherlands as it has the
highest ranking of the rule of law. Similarly, shareholder rights are negatively correlated with
leverage. This makes intuitive sense. The more the rights of the shareholders are protected,
the lower will be the risk faced by shareholders of the firm and the lower will be the relative
cost of equity. In lieu of a relatively lower cost of equity, equity may be preferred over debt.
38

Table 10
Institutional Factors in the Determination of Leverage
The table shows the results from an OLS regression. The t-statistics of the regression are reported in the brackets
and are corrected for heteroskedasticity. The dependent variable is given by the ratio of debt to total assets. I
include four additional independent variables as a proxy for institutional factors. The definitions of the
independent variables, including the institutional factors, are provided in the Appendix. *, **, *** denote
significance at the 10%, 5% and 1% level respectively.
Size
Growth
Profitability
Tangibility
Volatility
Creditor Rights
Anti-Director Rights
0.012***
(8.00)
-0.002
(-0.39)
-0.089***
(-3.75)
0.149***
(8.48)
0.263***
(5.65)
0.083***
(4.03)
-0.049***
(-2.45)
Public Firms
Leverage
0.012***
(8.00)
-0.002
(-0.39)
-0.089***
(-3.75)
0.149***
(8.48)
0.263***
(5.65)
Rule of Law
-0.172***
(-3.26)
0.134***
(4.64)
0.19
4379
Ownership Concentration
Adjusted R-squared
0.19
4379
0.003***
(3.08)
0.018***
(4.99)
-0.33***
(-22.31)
0.115***
(18.68)
0.166***
(5.01)
0.17***
(56.76)
-0.063***
(-21.98)
0.222
36222
Private Firms
Leverage
0.003***
(3.08)
0.018***
(4.99)
-0.33***
(-22.31)
0.115***
(18.68)
0.166***
(5.01)
-0.302***
(-40.69)
0.225***
(32.66)
0.222
36222
E. Robustness Tests
In order to check the robustness of the results, I employ three additional regressions. First, I
replace my independent variable. I use debt-to-capital as my measure of leverage. Capital is
defined as the sum of total debt and total shareholders funds. The results of the pooled panel
OLS regression are reported in Table 11. The results are robust against the debt to capital
ratio. Across the entire sample, with and without country dummies, leverage is positively
correlated to size of public firms, tangibility and volatility of both public and private firms and
is negatively correlated to the status of the firm, size and growth of private firms and
profitability of public and private firms. These results reinforce the findings of the regression
in Table 7. However, the coefficient of the growth of public firms is negatively correlated
with leverage and is significant at the 10% level. This is consistent with the findings of earlier
studies such as Rajan and Zingales and Frank and Goyal (2001). Important to note, the status
of the firm is highly significant across the entire sample. Public firms have approximately
55.3% lower debt as a percentage of total capital compared to private firms (as reported in the
first column without country dummies).
39

Across the subsample of individual countries, a few variables lose their significance against
the new measure of leverage but the results are consistent at large.
Table 11
The table shows the results from a pooled panel OLS regression for the entire sample and subsample of firms in
each country. The t-statistics of the regression are reported in the brackets and are corrected for
heteroskedasticity. The dependent variable is given by the ratio of debt to total capital. I interact each of my
independent variables with the status of the firm. Public and Private are dummy variables with Public taking the
value of 1 (0) if the firm is quoted (unquoted) and Private taking the value 1 (0) if the firm is unquoted (quoted).
Column 1 reports the results without the country fixed effects. Column 2 reports the regression results with the
inclusion of country dummies for the entire sample. The definitions of the independent variables are provided in
the Appendix. *, **, *** denote significance at the 10%, 5% and 1% level respectively.
All
Public
Public Size
Private Size
Public Growth
Private Growth
Public Tangibility
Private Tangibility
Public Volatility
Private Volatility
Germany
Netherlands
United Kingdom
-0.553***
-0.463***
-0.158
0.017
-0.418***
(-13.14)
(-11.2)
(-0.28)
(0.26)
(-9.05)
0.030***
0.038***
0.007
0.013***
0.035***
(10.27)
(13.23)
(0.19)
(3.07)
(10.96)
-0.005***
0.014***
0.006
0.013***
0.018***
(-3.35)
(9.4)
(0.92)
(6.75)
(9.05)
-0.018**
-0.016*
-0.181
0.012
-0.017*
(-1.99)
(-1.79)
(-1.39)
(0.52)
(-1.78)
0.017***
0.018***
0.132***
-0.01
0.017***
(2.68)
(3.19)
(2.96)
(-0.77)
(2.32)
-0.230***
-0.247***
-0.399
-0.28***
-0.222***
(-3.88)
(-4.26)
(-0.58)
(-3.97)
(-3.47)
-0.756***
-0.671***
-0.932***
-0.32***
-0.781***
(-23.19)
(-21.19)
(-8.15)
(-10.3)
(-18.96)
0.186***
0.194***
0.373
0.211***
0.15***
(7.91)
(8.17)
(1.31)
(4.5)
(5.88)
0.024***
0.028***
0.374***
0.086***
0.005
(2.45)
(3.08)
(8.49)
(5.96)
(0.43)
0.714***
0.703***
1.805
-0.09
0.728***
(6.16)
(6.3)
(1.53)
(-0.6)
(5.98)
0.616***
0.772***
0.07
-0.19***
0.986***
(8.29)
(10.79)
(0.29)
(-3.54)
(11.21)
Germany
0.025***
(2.610)
Netherlands
-0.307***
(-70.69)
Constant
0.436
0.307
0.341
-0.08
0.232
(18.35)
(13.32)
(3.7)
(-2.68)
(7.6)
No
Yes
Time Fixed Effects
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Adjusted R-squared
0.094
0.178
0.193
0.099
0.121
40424
40424
1920
10569
27935
40

Second, I replace the measures of three of my independent variables, namely growth, size and
profitability. I define growth as a two year growth in earnings before interest, tax and
depreciation (EBITDA). A growth in earnings gives an insight into the future growth of the
firm and its current investment opportunities. Similarly, I replace my profitability measure
with the net income margin. For size, I employ the natural logarithm of total assets. Again, the
results are robust against these new measures of growth, size and profitability as well. Across
the entire sample of firms, growth of public firms still remains insignificant whereas the
growth of private firms is negatively correlated with leverage. Similarly, profitability is
negatively correlated with leverage for both public and private firms across the entire sample.
Also, as reported initially, the leverage of private firms is more sensitive to profitability as
compared to public firms.
Results are robust against the cross country regressions as well. However, the growth variable
loses its significance for the subsample of UK and Netherlands firms. It appears that firms in
each of the countries increase or decrease leverage in response to their growth in sales rather
than earnings.
41

Table 12
The table shows the results from a pooled panel OLS regression for the subsample of firms in each country. The
t-statistics of the regression are reported in the brackets and are corrected for heteroskedasticity. The dependent
variable is given by the ratio of debt to total assets. I interact each of my independent variables with the status of
the firm. Public and Private are dummy variables with Public taking the value of 1 (0) if the firm is quoted
(unquoted) and Private taking the value 1 (0) if the firm is unquoted (quoted). Column 1 reports the results
without the country fixed effects. Column 2 reports the regression results with the inclusion of country dummies.
The definitions of the independent variables are provided in the Appendix. *, **, *** denote significance at the
10%, 5% and 1% level respectively.
All
Public
Public Size
Private Size
Public Growth
Private Growth
Public Tangibility
Private Tangibility
Public Volatility
Private Volatility
Germany
Netherlands
United Kingdom
-0.129***
-0.107***
-0.073
0.01
-0.041*
(-5.73)
(-4.78)
(-0.31)
(0.19)
(-1.68)
0.02***
0.023***
0.014
0.009***
0.021***
(12.94)
(15.11)
(0.96)
(2.64)
(12.33)
-0.015***
0.022***
0.007
0.009***
0.027***
(-13.91)
(20.56)
(1.5)
(5.37)
(20.46)
-0.001
-0.001
-0.128*
-0.018
0.002
(-0.12)
(-0.12)
(-1.64)
(-0.84)
(0.19)
-0.012*
-0.007**
0.027
-0.012
0.009
(-1.77)
(-1.98)
(1.25)
(-1.6)
(1.53)
-0.014***
-0.011**
-0.152*
-0.023
-0.016***
(-3.01)
(-2.27)
(-1.68)
(-1.22)
(-3.50)
-0.024***
-0.021***
-0.396***
-0.022
-0.017***
(-3.93)
(-3.44)
(-6.81)
(-1.07)
(-2.83)
0.167***
0.161***
0.089
0.216***
0.139***
(10.94)
(10.39)
(0.44)
(5.25)
(8.74)
0.157***
0.147***
0.444***
0.127***
0.136***
(21.41)
(21.15)
(14.65)
(10.48)
(16.68)
0.445***
0.439***
2.014***
0.107
0.448***
(7.61)
(7.49)
(3.55)
(0.43)
(7.56)
0.415***
0.474***
-0.105
-0.141***
0.593***
(8.11)
(9.67)
(-0.59)
(-3.34)
(10.7)
Germany
-0.012*
(-1.87)
Netherlands
-0.175***
(-57.92)
Constant
0.019
-0.021
0.109
-0.1
-0.09
(1.24)
(-1.45)
(1.71)
(-4.47)
-4.88)
No
Yes
Time Fixed Effects
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Adjusted R-squared
0.095
0.163
0.20
0.14
0.132
30684
30684
1789
5953
22942
42

Third, I adjust my dependent variable in line with one of the adjustments proposed by Rajan
and Zingales (1995). I exclude intangible assets from my analysis. This eliminates any impact
of goodwill arising from merger and acquisition activity which have little to do with the
capital structure of the firm. Hence, I subtract intangible assets from total assets and equity
correspondingly. The results of pooled panel regression with these changes are reported in
Table 13. The results are robust against this change as well. The coefficients across the entire
sample retain their stated relationship and their significance as well. Cross country analysis is
also consistent with earlier findings.
Table 13
The table shows the results from a pooled panel OLS regression for the subsample of firms in each country. The
t-statistics of the regression are reported in the brackets and are corrected for heteroskedasticity. The dependent
variable is given by the ratio of debt to total assets. The impact of intangible assets has been excluded from both
equity and total assets. I interact each of my independent variables with the status of the firm. Public and Private
are dummy variables with Public taking the value of 1 (0) if the firm is quoted (unquoted) and Private taking the
value 1 (0) if the firm is unquoted (quoted). Column 1 reports the results without the country fixed effects.
Column 2 reports the regression results with the inclusion of country dummies. The definitions of the
independent variables are provided in the Appendix. *, **, *** denote significance at the 10%, 5% and 1% level
respectively.
All
Public
Public Size
Private Size
Public Growth
Private Growth
Public Tangibility
Private Tangibility
Public Volatility
Private Volatility
-0.389***
(-9.09)
0.018***
(5.94)
-0.013***
(-8.8)
0.013
(1.07)
0.012**
(2.23)
-0.102***
(-2.36)
-0.409***
(-13.48)
0.046**
(1.95)
0.031***
(3.25)
0.324***
(3.11)
0.289***
(4.13)
Germany
Netherlands
Constant
Time Fixed Effects
Adjusted R-squared
0.428
(19.01)
No
Yes
Yes
0.075
40601
-0.306***
(-7.26)
0.026***
(8.51)
0.005***
(3.18)
0.014
(1.17)
0.013***
(2.65)
-0.119***
(-2.82)
-0.362***
(-12.12)
0.038*
(1.63)
0.026***
(2.82)
0.306***
(3.00)
0.417***
(6.14)
0.021**
(2.18)
-0.269***
(-69.28)
0.305
(13.69)
Yes
Yes
Yes
0.145
40601
43
Germany
Netherlands
United Kingdom
0.701
(1.34)
-0.03
(-0.9)
0.011
(1.46)
-0.063
(-0.58)
0.101***
(2.37)
-0.500
(-1.34)
-0.555***
(-3.66)
-0.059
(-0.27)
0.265***
(5.19)
0.092
(0.11)
-0.115
(-0.51)
0.063
(1.05)
0.008*
(1.81)
0.008***
(6.15)
0.063
(1.27)
-0.008**
(-2.25)
-0.056
(-1.18)
-0.03
(-1.49)
0.119***
(2.89)
0.053***
(5.48)
0.094
(0.57)
-0.163***
(-5.43)
-0.29***
(-5.99)
0.024***
(6.86)
0.006***
(2.99)
0.012
(0.96)
0.012*
(1.77)
-0.117***
(-2.53)
-0.435***
(-11.87)
0.103***
(3.87)
0.056***
(4.79)
0.285***
(2.56)
0.551***
(6.44)
0.185
(1.65)
Yes
Yes
0.113
1920
-0.062
(-3.08)
Yes
Yes
0.110
10738
0.262
(8.74)
Yes
Yes
0.092
27943

F. Limitations
The limitations of my research primarily pertain to the study of private firms. As there is only
limited information available on private firms, I cannot extend my analysis to other variables
such as dividend payouts, share price performance and market equity premium. The latter two
variables are particularly unavailable for private firms. Moreover, I can only employ the
measure of book leverage in my analysis as market value of equity for private firms cannot be
obtained. Though earlier studies like Rajan and Zingales (1995) and Fama and French (2002)
report consistent results across both book and market leverage, it would have been interesting
to include the analysis on market leverage in my study as well.
Another limitation of my study is the small sample size of German firms which might induce
selection bias. Though my initial sample of German firms is large, I eliminate firms that do
not report consolidated data and hence, am left with only a small sample size for Germany.
However, I attempt to eliminate this bias by first introducing country fixed effects in my
analysis and second, by providing a cross-country analysis.
VI.
Conclusion
The influential paper of Modigliani and Miller on capital structure irrelevancy has initiated
intense debate in corporate finance as to what determines the optimal capital structure of a
firm. Some theories such as the Pecking Order Theory have been proposed which attempt to
explain the capital structure of firms. These theories draw reference to the potential costs and
benefits regarding agency costs, transaction and bankruptcy costs and information asymmetry
in determining the financing behavior of firms.
This paper investigates the determinants of capital structure of a firm with respect to five
firm-specific characteristics, namely asset tangibility, profitability, growth, size and earnings
volatility. The sample data includes both public and private firms from Germany, the
Netherlands and the United Kingdom from the period 2003 to 2011. I set out to explore
whether the general theories of capital structure linked to public firms are applicable across
the private sector as well. I attempt to identify the characteristics that determine the leverage
of unquoted firms and to analyse the differences between the capital structure of public and
private firms. I further extend my investigation to provide a cross country analysis of the
differences in leverage. I try to explain these differences in light of institutional factors facing
each country.
44

My findings, from a pooled panel Ordinary Least Squares regression, suggest that private
firms have significantly higher leverage than public firms. Also, my results support the
traditional determinants of leverage. In the case of public firms, leverage is positively
correlated to size, tangibility and volatility and negatively correlated with profitability. The
relationship with growth is statistically insignificant. In the case of private firms, leverage
appears to be positively correlated with growth, tangibility and volatility and negatively
correlated with size and profitability, ceteris paribus. Hence, there seems to be a difference in
the financing behaviour of public and private firms with regards to size and growth
opportunities. Also, the leverage of private firms appears to be more sensitive to profitability
and less sensitive to the other factors compared to public firms.
However, a critical finding of my study is the importance of institutional factors in the
determination of capital structure of firms. My choice of the three countries provides an ideal
setup to study the relationship between leverage and institutional factors as these countries are
characterized by different legal traditions. The UK is defined by the English legal origin,
Germany by the Germanic legal origin and the Netherlands by the French legal origin.
Firms in the Netherlands are less levered whereas those in Germany are more highly levered
as compared to the firms in the United Kingdom. This can be explained in terms of creditor
rights protection. As the legal origin of the Netherlands allows for poor creditor protection, in
terms of bankruptcy laws, reorganization and automatic stays, Dutch firms have lower
leverage. This may be explained by possibly a higher cost of debt in the Netherlands to
incorporate the higher risk that lenders face. Also, firms in Germany have a high ownership
concentration. This suggests that these firms prefer to issue debt rather than equity in order to
avoid dilution of control of existing shareholders.
This paper fills two important gaps in existing literature. First, it incorporates the analysis of
capital structure determinants for unquoted firms which have largely been neglected due to
data unavailability. Second, it gives an insight into the importance of institutional factors in
the determination of capital structure. Future research now needs to be directed into the
examination of the relationship between institutional factors and leverage.
45

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49

Appendix
Figure A
Ratio of Debt to Total Assets over the years
The following figures show the development of the debt to total assets ratio for private and public firms across
the entire sample as well as individually across countries. Generally, it can be observed that leverage of private
firms has been consistently higher than the leverage of public firms over the years, with the exception of German
firms for the years 2007-09. One explanation might be the outbreak of the financial crisis which might have lead
German public firms to raise debt rather than equity.
A.1. Entire Sample

Average Debt to Total Assets for the Entire Sample
25.00%
% Debt to TA
20.00%
15.00%
Public Firms
10.00%
Private Firms
5.00%
0.00%
A.2. Germany
Average Debt to Total Assets for the German Firms
45.00%
40.00%
% Debt to TA
35.00%
30.00%
25.00%
Public Firms
20.00%
Private Firms
15.00%
10.00%
5.00%
0.00%
50

A.3. Netherlands
Average Debt to Total Assets for the Dutch Firms
25.00%
% Debt to TA
20.00%
15.00%
Public Firms
10.00%
Private Firms
5.00%
0.00%
A.4. United Kingdom

Average Debt to Total Assets for the UK Firms
40.00%
35.00%
% Debt to TA
30.00%
25.00%
20.00%
Public Firms
15.00%
Private Firms
10.00%
5.00%
0.00%
51

Table A
Correlation of Variables
The table shows the correlation between the dependent and independent variables. As can be seen, the two
proxies for leverage, debt to total assets and debt to total capital are highly positively correlated. The correlation
matrix shows that leverage is positively correlated to growth, tangibility and volatility whereas negatively
correlated to size and profitability across the entire sample.
Correlation Matrix
Debt to
Assets
Debt to
Capital
Size
Debt to Assets
Debt to Capital
0.8093
Size
-0.1211
-0.0641
Growth
Profitability Tangibility
Growth
0.0123
0.0016
0.0232
Profitability
-0.1955
-0.2492
0.246
0.0515
Tangibility
0.160
0.013
-0.0564
-0.0461
0.0056
Volatility
0.0975
0.2106
-0.2078
0.0756
-0.4208
-0.173
Volatility
Table B
Institutional Factors as reported by La Porta et al. (1998).
The legal tradition and the legal origin pertain to the laws governing the respective countries. Creditor rights is
an index rating on a scale from 0-4 (4 being the most highly protected creditors) depending on the rights of the
creditors on different metrics. Anti-director rights is also an index rating and is a proxy for shareholder rights.
The scale ranges from 0-6 (6 being the most strongly protected shareholder rights). Ownership concentration is
the average percentage of common shares owned by the three largest shareholders in the ten largest non-financial
firms. Rule of law is the degree of enforcement of the law on a scale of 0 to 10 (10 being the most highly
enforced). For a more detailed discussion of these variables, please refer to La Porta et al. (1998).
Germany
Netherlands
United Kingdom
Code
Code
Common
Germanic
French
English
Creditor Rights
Anti-Director Rights
Ownership Concentration (%)
0.48
0.39
0.19
Rule of Law
9.23
10.00
8.57
Legal Tradition
Legal Origin
Table C
Definition of Variables
Total Debt
Long-term debt + Short-term debt
Total Capital
Total debt + Shareholders funds
Total debt / Total Assets
Total debt / Total Capital
Firm Size
Natural Log (Turnover)
Growth
(Turnover t / Turnover t-1 ) 1
52

Profitability (Return on Assets)
Operating Income / Total Assets
Tangibility
Natural Log (Tangible Assets)
Earnings Volatility
Three year standard deviation in Profitability
53

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Master Thesis

The Determinants of Capital Structure: A Comparative

Submitted by: Z. Afzal

Determinants of Capital Structure:

Determinants of Capital Structure:

Determinants of Capital Structure:

Determinants of Capital Structure:

Determinants of Capital Structure:

Determinants of Capital Structure:

Determinants of Capital Structure:

Determinants of Capital Structure:

Determinants of Capital Structure:

Relationship between Leverage and Firm-Characteristics

Frank and Goyal

Determinants of Capital Structure:

Shuetrim, Lowe and Morling

Relationship between Leverage and Firm-Characteristics

Deloof and Verschueren (1998)

Schoubben and Hulle (2004)

Determinants of Capital Structure:

Determinants of Capital Structure:

E.3. Asset Tangibility

Determinants of Capital Structure:

Determinants of Capital Structure:

Determinants of Capital Structure:

Determinants of Capital Structure:

Determinants of Capital Structure:

Determinants of Capital Structure:

Determinants of Capital Structure:

Determinants of Capital Structure:

Amadeus is a comprehensive database containing financial information for over 19 million

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Determinants of Capital Structure:

Determinants of Capital Structure:

Determinants of Capital Structure:

Determinants of Capital Structure:

Debt to Total Assets

Debt to Net Assets

Nonequity Liabilities to Total Assets

Debt to Total Capital

Determinants of Capital Structure:

Determinants of Capital Structure:

Determinants of Capital Structure:

Determinants of Capital Structure:

Debt to Total Assets

Debt to Total Capital

Short-term Debt to Total Debt

Cash to Total Assets

Total Assets ( 000)

Determinants of Capital Structure:

Debt to Total Assets

Debt to Total Capital

Short-term Debt to Total Debt

Cash to Total Assets

Total Assets ( 000)

Determinants of Capital Structure:

Determinants of Capital Structure:

Determinants of Capital Structure:

Determinants of Capital Structure:

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Determinants of Capital Structure:

Determinants of Capital Structure:

Time Fixed Effects

Determinants of Capital Structure: