The capital structure of Swiss companies: an empirical analysis using dynamic panel data

Philippe Gaud*, Elion Jani**, Martin Hoesli*** and Andr Bender****

This draft: 21 January 2003

Abstract In this paper, we analyze the determinants of the capital structure for a panel of 106 Swiss companies listed in the Swiss stock exchange. Both static and dynamic tests are performed for the period 1991-2000. It is found that the size of companies, the importance of tangible assets and business risk are positively related to leverage, while growth and profitability are negatively associated with leverage. The sign of these relations suggest that both the pecking order theory and trade off hypothesis are at work in explaining the capital structure of Swiss companies, although more evidence exists to validate the latter theory. Our analysis also shows that Swiss firms adjust toward a target debt ratio, but the adjustment process is much slower than in most other countries. It is argued that reasons for this can be found in the institutional context.

JEL classification: G32 Keywords: Capital structure, dynamic panel data, trade-off theory, pecking order theory
*

University of Geneva (HEC), 40 boulevard du Pont-dArve, CH-1211 Geneva 4, Switzerland, email: philippe.gaud@hec.unige.ch ** University of Geneva (HEC), 40 boulevard du Pont-dArve, CH-1211 Geneva 4, Switzerland, email: elion.jani@hec.unige.ch *** University of Geneva (HEC and FAME), 40 boulevard du Pont-dArve, CH-1211 Geneva 4, Switzerland and University of Aberdeen (Business School), Edward Wright Building, Dunbar Street, Aberdeen AB24 3QY, UK, email: martin.hoesli@hec.unige.ch **** University of Geneva (HEC and FAME), 40 boulevard du Pont-dArve, CH-1211 Geneva 4, Switzerland, email: andre.bender@hec.unige.ch Address correspondence to: Martin Hoesli, University of Geneva, HEC, 40 boulevard du Pont-dArve, CH-1211 Geneva 4, Switzerland, email: martin.hoesli@hec.unige.ch We thank Jaya Krishnakumar and Andi Kabili for helpful discussions and suggestions. We are also grateful to the participants at the University of Geneva (HEC) finance research seminars. The usual disclaimer applies.

The capital structure of Swiss companies: an empirical analysis using dynamic panel data

1. Introduction Since the seminal Modigliani and Miller (1958) paper showing that subject to some conditions the impact of financing on the value of the firm is irrelevant, the literature on capital structure has been expanded by many theoretical and empirical contributions. Much emphasis has been placed on releasing the assumptions made by MM, in particular by taking into account corporate taxes (Modigliani and Miller, 1963), personal taxes (Miller, 1977), bankruptcy costs (Stiglitz, 1972; Titman, 1984), agency costs (Jensen and Meckling, 1976; Myers, 1977), and informational asymmetries (Myers, 1984). Two main theories dominate currently the capital structure debate1: the trade off theory (TOT) and the pecking order theory (POT).

The TOT posits that firms maximize their value when the benefits that stem from debt (the tax shield, the disciplinary role of debt, and the fact that debt suffers less from informational costs than outside equity) equal the marginal cost of debt (bankruptcy costs, and agency costs between shareholders and bondholders). The POT, developed by Myers (1984), is a consequence of informational asymmetries existing between insiders of the firm and outsiders (i.e. the capital market). Thereafter, addressing the issue of how companies choose their financing mix has been primarily an empirical question, and such studies have been plentiful in the last decade. However, empirical studies dealing with capital structure are not recent (Taggart, 1977; Marsh, 1982; Jalilvand and Harris, 1984; Titman and Wessels, 1988). The latter authors made a significant contribution in formulating and testing the determinants of the capital structure as identified by theory. These authors caution on the difficulty of finding suitable proxies for the determinants of capital structure.

Most initial studies examined the case of U.S. companies. The cross section analysis by Rajan and Zingales (1995) is one of the first attempts to test for the G7 countries the theoretical and empirical lessons learnt from the U.S. studies. These authors find similar levels of leverage across countries, thus refuting the idea that firms in bank-oriented countries are more
1

For an in-depth review of literature on capital structure, see Harris and Raviv (1991).

leveraged than those in market-oriented countries. However, they recognize that this distinction is useful in analyzing the various sources of financing. Rajan and Zingales (1995) find that the determinants of capital structure that have been reported for the U.S. (size, growth, profitability, and importance of tangible assets) are important in other countries as well. They show that a good understanding of the relevant institutional context (bankruptcy law, fiscal treatment, ownership concentration, and accounting standards) is required when identifying the fundamental determinants of capital structure. The analysis by Booth et al. (2001) suggests that the same determinants of capital structure prevail in ten developing countries. These studies, however, do not shed any light on the adjustment process of the capital structure.

Other studies, which have addressed the dynamic nature of capital structure decisions, suffer from some limitations also. For example, the results of Taggart (1977), Marsh (1982), and Jalilvand and Harris (1984) may be biased as they use future information about leverage as a proxy of the optimal debt ratio. Moreover, the tests of the target adjustment model lack power as they are unable to reject the target adjustment hypothesis even when financing is generated according to POT only (Shyam-Sunders and Myers, 1999). With respect to the empirical validation of pecking order theory, Chirinko and Singha (2000) show that the tests by ShyamSunders and Myers (1999) may be misleading. In addition, Frank and Goyal (2002) reject the fact that the debt level is determined fundamentally by the financing deficit, and find evidence of mean reversion of leverage, the adjustment process being influenced by the variables used by Rajan and Zingales (1995).

Recent work has benefited from the advances in econometrics. Kremp et al. (1999), De Miguel and Pindado (2001), and Ozkan (2001) focus on the dynamics of the capital structure decisions, offering better insight on the adjustment process toward the target debt-to-equity ratio. Kremp et al. (1999) analyze a large panel of French and German firms and confirm the existence of a dynamic adjustment process. They provide further evidence that the institutional framework is important when analyzing the determinants of the capital structure. They stress the role of the Hausbank system in Germany, and the impact of tax policy and the end of the so-called indebtedness economy in France. These findings are confirmed by De Miguel and Pindado (2001) who show that firms have a target leverage ratio in Spain, and that companies adjust to the target ratio relatively fast. The institutional context again is

important. They argue that adjustment costs are lower in Spain than in the U.S. for instance, because of the major role of bank financing.

The aim of this paper is to analyze the determinants of the capital structure in Switzerland. We add to the relatively limited literature on the dynamics of the capital structure decision by examining the dynamics of the relationship between leverage and a set of explanatory variables. The analysis is conducted using panel data pertaining to 106 Swiss companies for the period 1991-2000. A total of 967 observations are available for analysis. Our results show that both the pecking order theory and the trade off theory are at work, although more evidence exists to validate the latter theory. Also, we find that the speed of adjustment is quite slow in Switzerland as compared to other countries. We argue that the complexity and specificity of the Swiss institutional framework help explain why Swiss firms do not suffer too much from being away from their target ratios.

The paper is organized as follows. In section 2, we provide an overview of the literature on the determinants of the capital structure. The models and the data are presented in section 3, while the results from using both the static and dynamic models are discussed in section 4. Finally, section 5 contains some concluding remarks.

2. The determinants of capital structure In this section, we provide a review of the six main variables that have been used in previous studies examining the determinants of capital structure. 2.1 Growth opportunities For companies with growth opportunities, the use of debt is limited as in the case of bankruptcy, the value of growth opportunities will be close to zero. Jung et al. (1996) show that firms should use equity to finance their growth because such financing reduces agency costs between shareholders and managers, whereas firms with less growth prospects should use debt because it has a disciplinary role (Jensen, 1986; Stulz, 1990).

Myers (1977) shows that firms with growth opportunities may invest sub-optimally, and therefore creditors will be more reluctant to lend for long horizons. This problem can be solved by short-term financing (Titman and Wessels, 1988) or by convertible bonds (Jensen

and Meckling, 1976; Smith and Warner, 1979). From a pecking order theory perspective, growth firms with strong financing needs will issue securities less subject to informational asymmetries, i.e. short-term debt. If these firms have very close relationships with banks, there will be less informational asymmetry problems, and they will be able to have access to long term debt financing as well.

A common proxy for growth opportunities is the market value to book value of total assets. Firms with growth opportunities should exhibit a greater market-to-book than firms with less growth opportunities, but Harris and Raviv (1991) suggest that this is not necessarily the case. This will typically occur when assets whose values have increased over time have been fully depreciated, as well as when assets with high value are not accounted for in the balance sheet (e.g. the brand name Nestl).

Rajan and Zingales (1995) find a negative relationship between growth opportunities and leverage. They suggest that this may be due to firms issuing equity when stock prices are high. As mentioned by Hovakimian et al. (2001), large stock price increases are usually associated with improved growth opportunities, leading to a lower debt ratio.

2.2 Size Large size companies tend to be more diversified, and hence their cash flows are less volatile. Size may then be inversely related to the probability of bankruptcy (Titman and Wessels, 1988; Rajan and Zingales, 1995). Ferri and Jones (1979) suggest that large firms have easier access to the markets and can borrow at better conditions. For small firms, the conflicts between creditors and shareholders are more severe because the managers of such firms tend to be large shareholders and are better able to switch from one investment project to another (Grinblatt and Titman, 1998). However, this problem may be mitigated with the use of short term debt, convertible bonds, as well as long term bank financing. Most empirical studies report indeed a positive sign for the relationship between size and leverage (Rajan and Zingales, 1995; Frank and Goyal, 2002; Booth et al., 2001). Less conclusive results are reported by other authors (Kremp et al., 1999; Ozkan, 2001). For Germany, however, Rajan and Zingales (1995) find that a negative relationship exists. Kremp et al. (1999) confirm the finding of Rajan and Zingales (1995) for Germany and argue that the negative relationship is not due to asymmetrical information, but rather to the characteristics of the German 6

bankruptcy law and the Hausbank system which offer better protection to creditors than is the case in other countries.

2.3 Profitability One of the main theoretical controversies concerns the relationship between leverage and profitability of the firm. According to the pecking order theory, firms prefer using internal sources of financing first, then debt and finally external equity obtained by stock issues. All things being equal, the more profitable the firms are, the more internal financing they will have, and therefore we should expect a negative relationship between leverage and profitability. This relationship is one of the most systematic findings in the empirical literature (Harris and Raviv, 1991; Rajan and Zingales, 1995; Booth et al., 2001).

In a trade-off theory framework, an opposite conclusion is expected. When firms are profitable, they should prefer debt to benefit from the tax shield. In addition, if past profitability is a good proxy for future profitability, profitable firms can borrow more as the likelihood of paying back the loans is greater.

Dynamic theoretical models based on the existence of a target debt-to-equity ratio show (1) that there are adjustment costs to raise the debt-to-equity ratio towards the target and (2) that debt can easily be reimbursed with excess cash provided by internal sources. This leads firms to have a pecking order behavior in the short term, despite the fact that they aim at increasing their debt-to-equity ratio (Fischer et al., 1989; Leland, 1998).

2.4 Collaterals Tangible assets are likely to have an impact on the borrowing decisions of a firm because they are less subject to informational asymmetries and usually they have a greater value than intangible assets in case of bankruptcy. Additionally, the moral hazard risks are reduced when the firm offers tangible assets as collateral, because this constitutes a positive signal to the creditors who can request the selling of these assets in the case of default. As such, tangible assets constitute a good collateral for loans. According to Scott (1977), a firm can increase the value of equity by issuing collateralized debt when the current creditors do not have such

guarantee. Hence, firms have an incentive to do so, and one would expect a positive relation between the importance of tangible assets and the degree of leverage.

Based on the agency problems between managers and shareholders, Harris and Raviv (1990) suggest that firms with more tangible assets should take more debt. This is due to the behavior of managers who refuse to liquidate the firm even when the liquidation value is higher than the value of the firm as a going concern. Indeed, by increasing the leverage, the probability of default will increase which is to the benefit of the shareholders. In an agency theory framework, debt can have another disciplinary role: by increasing the debt level, the free cash flow will decrease (Grossman and Hart, 1982; Jensen, 1986; Stulz, 1990). As opposed to the former, this disciplinary role of debt should mainly occur in firms with few tangible assets, because in such a case it is very difficult to monitor the excessive expenses of managers.

From a pecking order theory perspective, firms with few tangible assets are more sensitive to informational asymmetries. These firms will thus issue debt rather than equity when they need external financing (Harris and Raviv, 1991), leading to an expected negative relation between the importance of intangible assets and leverage.

Most empirical studies conclude to a positive relation between collaterals and the level of debt (Rajan and Zingales, 1995; Kremp et al., 1999; Frank and Goyal, 2002). Inconclusive results are reported for instance by Titman and Wessels (1988).

2.5 Operating Risk Many authors have included a measure of risk as an explanatory variable of the debt level (Titman and Wessels, 1988; Kremp et al., 1999; Booth et al., 2001). Leverage increases the volatility of the net profit. Firms that have high operating risk can lower the volatility of the net profit by reducing the level of debt. By so doing, bankruptcy risk will decrease, and the probability of fully benefiting from the tax shield will increase. A negative relation between operating risk and leverage is also expected from a pecking order theory perspective: firms with high volatility of results try to accumulate cash during good years, to avoid under investment issues in the future.

2.6 Taxes The impact of taxation on leverage is twofold. On the one hand, companies have an incentive to take debt because they can benefit from the tax shield. On the other hand, since revenues from debt are taxed more heavily than revenues from equity, firms also have an incentive to use equity rather than debt. As suggested by Miller (1977), the financial structure decisions are irrelevant given that bankruptcy costs can be neglected in equilibrium. DeAngelo and Masulis (1980) show that if non-debt tax shields exist, then firms are likely not to use fully debt tax shields. In other words, firms with large non-debt tax shields have a lower incentive to use debt from a tax shield point of view, and thus may use less debt. Empirically, this substitution effect is difficult to measure as finding an accurate proxy for the tax reduction that excludes the effect of economic depreciation and expenses is tedious (Titman and Wessels, 1988). According to Graham (2000), the tax shield accounts on average to 4.3% of the firm value when both corporate and personal taxes are considered.

3. Models and Data

3.1

Static Model

The static model tests the Modigliani and Miller (1958) hypothesis that leverage is a random variable. More specifically, the leverage is regressed on a set of explanatory variables, and if MM holds, then these variables should not be significant from a statistical point of view. We use explanatory variables to proxy for the determinants of capital structure as presented in section 2. We do not take into account the tax effect for two reasons. First, this would reduce substantially the size of our sample due to the lack of data regarding taxes. Moreover, choosing the appropriate marginal tax rate of firms is crucial in determining the tax shield and such choice is not straightforward (Graham, 2000). We posit that leverage can be explained by the following variables:

Leverage = f(growth, size, profitability, tangibles, risk)

We use two proxies to measure the leverage. The first proxy refers to book values only and is defined as the ratio of total debt over total assets. The other proxy is based on the market capitalization of equity. Two measures of leverage are used to control for possible spurious 9

correlations that may result from a discrepancy between one of our proxies for leverage and the debt-to-equity ratio computed by the managers (Titman and Wessels, 1988). It is important to obtain the same sign from the various explanatory variables whether we use market capitalization or book value. To check further the robustness of our results, we also run the regressions by only considering long term debt. Although these results are not reported in the tables, they are discussed whenever necessary.

Growth opportunities (GROWTH) are proxied by the market-to-book value of assets. Other proxies also have been used in the literature, such as R&D and marketing expenses, or capital expenditures (Titman and Wessels, 1988), but such items are difficult to measure from published financial statements, and hence are not considered in this study. We use the natural logarithm of sales as proxy for size (SIZE). This measure is the most common proxy for size (Titman and Wessels, 1988; Rajan and Zingales, 1995; Ozkan, 2001). An alternative proxy could be the natural logarithm of total assets, but it is subject to more accounting problems. Various proxies can be used to measure profitability (PROF). We choose the return on total assets, which is calculated as the ratio of EBIT to total assets (Rajan and Zingales, 1995; Booth et al., 2001). We use the ratio of the sum of tangible assets and inventories to total asset as a proxy for collaterals (TANG). Adding inventories to the tangible assets is motivated by the fact that debts are used partly to finance inventories, and in most cases inventories maintain some value when the firm is liquidated (Kremp et al., 1999).

Proxying for the operating risk is a difficult task because such a measure should rely on expectations concerning a firms profitability as compared to that of the market and should also take into account the specific nature of the firms assets. Many authors use the volatility of operating profits of each company as a proxy (Titman and Wessels, 1988; Booth et al., 2001). Kremp et al. (1999) measure the operating risk as the squared difference between the firms profitability and the cross section mean (i.e. across firms) of profitability for each year. We add to this squared measure the sign of the difference between the profitability of the firm and the average profitability. This measure is better than using the more intuitively appealing difference as the latter is highly collinear with the PROF variable.

Legal differences across countries, varying degrees of exports by companies, the nature of the business and the risk profile of shareholders and managers suggest that the Swiss firms are very different from each other. Furthermore it is likely that macroeconomic shocks and 10

changes in the institutional context have occurred in recent years. For these purposes, we prefer panel data analysis, as it is possible to include time effects as well as to control for the heterogeneity of firms by including firm-specific effects, which may be random or fixed. However, the fixed effects model is costly in degrees of freedom because it is equivalent to the use of a dummy variable for every firm (Greene, 1993). The random effects model assumes the independence between error terms and explanatory variables. Chow tests are performed in this study to control for the presence of firm specific effects (Hsiao, 1986). The Hausman test is then performed to validate the exogeneity of the firm specific effect with dependent variables (Hausman, 1978). If the two null hypotheses are rejected, then the fixed effect model will be retained. A Wald test of the joint significance of time dummy variables is also used.

In order to ease comparison, we also report simple pooled ordinary least squares as well as pooled ordinary least squares with dummy variable for time and sectors and Fama-McBeth type estimations.

Our static model to analyze firms with panel data is as follows: yit = ' xit + i + t + uit with i = 1,.,N and t=1,.,T and yit : the leverage of firm i in year t xit : a K x 1 vector of explanatory variables : a K x 1 vector of constants i : firm effect assumed constant for firm i over t t : time effect assumed constant for given t over i uit : error term (1)

3.2

Dynamic Model

Capital structure decisions are dynamic by nature and should be modelled as such. If there is a target leverage ratio, then firms should take the appropriate steps to reach this objective. Claiming that the adjustment process is without cost is unrealistic. Taking transaction costs into account, the model can be written as follows:

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* yit yit 1 = yit yit 1

(2)

with 0< <1

* where yit is the target leverage ratio estimated from equation (1).

The coefficient is between 0 and 1 and is inversely related to adjustment costs. When

=0, then yit = yit-1, which means that there is no move toward the target debt ratio because
* the adjustment costs are too high. When =1, then yit = yit , so the adjustment occurs without

frictions. Once developed, equation (2) becomes:

y it = (1 ) y it 1 + xit + i + t + u it

(3)

Panel data analysis allows us to study the dynamic nature of the capital structure decisions at the firm level. However, the fixed or random effects models may give biased and inconsistent estimators because the error term may be correlated with the lagged variable. To deal with variables that may be correlated with the error term, we use instrumental variables. Using instrumental variables has the additional advantage of solving problems encountered in static models, mainly the simultaneity bias between the leverage measure and the explanatory variables, and measurement error issue. For panels with a limited number of years and a substantial number of observations, Arellano and Bond (1991) suggest estimating equation (3) in first differences2 and using all lags of the level of variables from the second lag as instruments.

We use the Arellano and Bond (1991) two-step GMM estimator for our dynamic model which allows for heteroskedasticity across firms. The GMM estimator is consistent if there is no second order serial correlation between error terms of the first-differenced equation. A m2 statistic which follows a N(0,1) distribution under the null hypothesis E[it, it-2]=0 is used to test for lack of second order serial correlation. Concerning the instruments, we report the Sargan statistic, which tests the over-identifying restrictions. It must be noted that the Sargan test rejects too often in presence of heteroskedasticity. In addition, we report two Wald statistics. Wald 1 is a test of the joint significance of the time dummy variables and is
2

Using first differences eliminates the specific firm effect, thus avoiding any correlation problem between unobservable firm specific characteristics and explanatory variables.

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asymptotically distributed as 2 under the null hypothesis of no relationship. Wald 3 is a test of the joint significance of the capital structure determinants.

Arellano and Bond (1991) show that when the number of firms is limited, the asymptotic standard errors associated with the two-step estimates may be biased downward. However, the one-step estimators are less efficient than the two-step estimators even in presence of homoskedasticity of the error terms. Since the standard errors associated with the one-step estimators are more reliable to make inferences, the results using both methods are reported in this study.

3.3

Data

Our data consist of Swiss firms listed on the Swiss stock exchange SWX for the period 19912000. We use annual data extracted from Worldscope. Banks, insurance companies, utility companies, and some other companies, whose business is highly regulated, such as railway companies, are excluded from the sample. This is motivated by the fact that such companies have to comply with very stringent legal requirements pertaining to their financing. Our sample thus contains primarily industrial, commercial and service companies, for which managers have considerable leeway concerning financial decisions.

We deflate our data using 1992 as base year. Company financial statements and the Swiss stock guide are used to fill any gaps in the data, and to check the data. We exclude observations (i.e. a given company in a given year) for which we have negative figures on the balance sheet, except for retained earnings and other assets3. Our sample is trimmed applying a methodology similar to that of Kremp et al. (1999). We exclude observations for which profitability, collaterals and growth opportunities are outside the interval defined by plus/minus five times the interquartile range. Concerning the measure of leverage, we only exclude observations for which the leverage is higher than the third quartile plus five times the interquartile range. We choose the period 19912000 because a new business law required Swiss firms to comply with new accounting rules since 1991. Before 1991, there would be too many missing observations. To run the dynamic panel regressions, we need a minimum of six

When firms adopted the new accounting rules in the beginning of the 1990s, a badwill might have appeared, and hence negative other assets may exist.

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consecutive years for a company to be included. This leaves us with a sample of 106 firms and a total of 967 observations.

Table I contains summary statistics for selected years of the time period (1991, 1994, 1997, and 2000), as well as for the total period 1991-2000. The importance of leverage diminishes over the period, with a sharper decrease when market values of equity are considered than when book values are used. Whereas both proxies for leverage are roughly equal in 1991, this leverage ratio amounts to 54.2% in 2000 when market values are used and to 40.2% when book values are used. Over the period, companies on average have grown in size, and have increased the relative importance of intangible assets in their balance sheet. The market-tobook ratio has increased from 1.10 in 1991 to 1.87 in 2000, but remains low which confirms the fact that the Swiss market is a value market rather than a growth market. The profitability of Swiss companies has increased over the period, and not surprisingly the higher return levels are accompanied by higher levels of risk.

The correlation coefficients between variables are reported in Table II. Correlations are generally low, except the correlation between profitability and risk. In fact, a high correlation between these two variables would be expected. To check whether these two variables are collinear, we perform a VIF test. Our VIF tests are substantially lower than 10, so collinearity should not constitute a problem (Chaterjee and Price, 1977).

4.

Results

4.1 Static Analysis In table III we present the regression results for the static analysis. The level of R2 varies from 14.3% to 60.0%. The R2s are substantially higher when the market capitalization of equity is used rather than the book value of equity. The Chow test is significant at the 1% level, and confirms the presence of firm-specific effects. The Hausman test indicates that the fixed effect model should be used when market data are considered, whereas the random effect model should be preferred when using book values. When such estimators are considered, all variables are significant at the 1% level, except the RISK variable when book values are considered. The Wald 1 tests of the joint significance of the time dummy variables are satisfied, except when book values are used for panel estimation, suggesting that

14

macroeconomic events and changes in the institutional context play a significant role on the borrowing decision of Swiss firms.

SIZE plays a positive role and the coefficients are significant for all estimations. For the profitability variable (PROF), we find a negative relationship with leverage and all the coefficients are again significant at the 1% level. For the other three variables, the results vary more across specifications. The RISK variable is positively related to the importance of leverage and in all cases significant at the 1% level when the market values of equity are considered, but not when book values are considered. The GROWTH variable negatively impacts on leverage and is significant at the 1% level when market values are used only, but is significant in all cases with panel data estimations. Tangible assets (TANG) have a positive impact that is significant at the 1% level for all panel data estimations and for the OLS estimations with market values. In summary, when panel data are used, the SIZE, TANG, and RISK variables have a positive impact on leverage, whereas GROWTH and PROF have a negative impact. All these relations are significant at the 1% level when either market values or book values of equity are used, except for the SIZE variable, which is only significant when market values are used.

When using long-term debt in lieu of total debt to compute the leverage, the tests confirm that firm-specific effects exist and that the random effects models give the best estimations. We obtain the same sign and the same significance for all coefficients, except for the RISK variable, which is now significant at the 5% level when using book values and the variable SIZE, which looses its significance.

The positive impact of size on leverage is consistent with the results of many empirical studies (Rajan and Zingales, 1995; Booth et al., 2001; Frank and Goyal, 2002). It leads us to reject the hypothesis that size acts as an inverse proxy for informational asymmetries, but could suggest that size acts as an inverse proxy for the probability of bankruptcy. Recall that the variable SIZE is not significant any more when leverage is computed with long-term debt only. One possible explanation is that large companies have easier access to the bond markets (Ferri and Jones, 1979). The development of financial markets has pushed large companies to search for better credit conditions. Consequently, there has been a tendency for banks to grant more loans to small and medium size companies. The market for short term debt securities

15

being not well developed in Switzerland, this allows banks to select between borrowers. As they will prefer large firms to small ones, the sign of the SIZE coefficient is positive.

As reported in several other studies, the PROF variable is negative and significant in all cases (Rajan and Zingales, 1995; Booth et al., 2001; Frank and Goyal, 2002). This finding provides support for the pecking order theory. However, caution has to be exercised before the dynamic nature of the relation between leverage and profitability is examined (Frank and Goyal, 2002; Titman and Wessels, 1988). The positive impact of RISK for the fixed effects estimation when using market data implies that firms, which perform below average, are less levered. In other words, companies with high operating risk try to control total risk by limiting financial risk.

The coefficient of the TANG variable is positive and significant for the panel data estimations, and this result is similar to those reported in previous research (Rajan and Zingales, 1995; Kremp et al., 1999; Frank and Goyal, 2002). This result suggests that firms use tangible assets as collateral when negotiating borrowing, especially long term borrowing. The observed sign of the relationship does not confirm the sign that would be expected when using the pecking order theory framework. In such a framework, firms with less tangible assets are more subject to informational asymmetries, and are more likely to use debt principally short term debt - when they need external financing.

The negative sign of GROWTH confirms the hypothesis that firms with growth opportunities are less levered. To analyze further this relationship, we divide our sample in two subsamples using the median growth as cut-off. The negative sign and significance of the coefficient remains irrespective of the leverage measure for the high growth firms. Concerning the low growth firms, which are typically no growth firms as the market-to-book ratio is below one, we observe a negative relationship between GROWTH and leverage when market values are used, and a positive relation when leverage is measured with book values.

The latter relation can be explained by the fact that in our sample companies with low growth opportunities typically belong to either of the following two categories: (1) companies with cash-cow activities or (2) companies in financial distress. For the former type of company, current activities generate sufficient cash to renew assets, and even to support a marginal increase of assets. Any remaining cash will increase cash and cash equivalents. Retained 16

earnings will increase also, leading to a lower leverage ratio. Moreover, as highlighted by La Porta et al. (1998), these companies are often family-owned (such as Loeb, Vetropak, and Bucher), and have a strong tax incentive not to distribute any remaining cash. In addition, the repurchase of shares is too costly for this type of company. For companies in financial distress (such as Axantis, and WMH), banks are reluctant to lend funds, as the prospects are not encouraging. In some cases, these companies have been forced to sell some of their activities, often with a capital gain, making it possible to reduce the debt-to-equity ratio level. When market values are used, the above-mentioned financial operations will have a strong negative impact on the market value of equity4. Therefore, the debt-to-equity ratio may even increase. 4.2 Dynamic Analysis

The dynamic analysis makes it possible to study the financing behavior of Swiss firms over time and whether there are adjustment costs. As the model is estimated in first differences and one or more lagged variables are used as explanatory variables, our sample is reduced from 967 to 755 observations. To examine the impact of profitability over the dynamics of borrowing, we add the lagged profitability in equation (3). This is motivated by the fact that we want to test the persistence of a pecking order financing, which we find in our static model. Models such as those of Fischer et al. (1989) and Leland (1998) postulate the existence of an optimal debt-to-equity ratio, but find pecking order behavior in the short run due to the adjustment costs. Despite the fact that the contemporaneous profitability is a determinant of the importance of leverage, the cash flow generated during the year can be used partly to decrease the level of debt.

For the dynamic model, we test various specifications concerning the endogeneity of the explanatory variables. Only the results of the model that posits that all variables are endogenous are reported in this paper. Not surprisingly, this is the best-specified model because all variables are based upon accounting values and are thus determined simultaneously. Arellano and Bond (1991) show that two-step estimators may be biased for small samples and recommend the use of a one-step estimator to draw inferences. We present the two types of estimations in table IV, however. The Sargan and m2 tests suggest that a dynamic specification of our model for the sample of Swiss firms is valid. Only the Sargan

As mentioned by Goyal et al. (2002), the change of sign may also be a statistical phenomenon because book leverage and MTB have the same denominator.

17

test for the one-step estimator does not confirm the validity of our instrumental variables. However, as Arellano and Bond (1991) note, the Sargan test has an tendency to reject too often in the presence of heteroskedasticity.

The size of the coefficient of the lagged leverage is high and it is in all cases significant at the 1% level. For the Swiss market, the size of the coefficient is in the 0.708-0.844 range for the one-step estimations. The coefficient is smaller when we use market data suggesting that managers use market values when adjusting their leverage toward the target ratio. Caution has to be exercised when cross-country comparisons are made, but such comparisons are interesting however. The adjustment process is slow in Switzerland compared to the results for other countries as reported in many studies: De Miguel and Pindado (2001) find a (1-) of 0.21 for Spain, Shyam-Sunder and Myers (1999) a value of 0.41 for the U.S., Kremp et al. (1999) a value of 0.47 for Germany, and Ozkan (2001) a value of 0.45 for the U.K. For France, the speed of adjustment is comparable to that for Switzerland as 1- = 0.72 as reported by Kremp et al. (1999).

The adjustment process is a trade off between the adjustment costs towards a target ratio and the costs of being in disequilibrium. If the costs of being in disequilibrium are greater than the adjustment costs, then the estimated coefficient should be close to zero (Ozkan, 2001). For example, De Miguel and Pindado (2001) explain the small coefficient that they find for the Spanish market by the importance of bank credit. They argue that Spanish companies have low transaction costs when borrowing funds from banks, and that such financing leads to lower agency costs between creditors and shareholders. It could seem appropriate to use the same explanation for the Swiss market because companies in both countries mostly rely on banks for their long term borrowing needs. According to the World Bank (1999), the public debt ratio is 5.7% for Spain and 7.9% for Switzerland, as compared e.g. to 27.4% for the U.S. However, the reason used to explain the adjustment process for Spain does not necessarily hold for Switzerland. Unlike Spain, which was in a boom market during the 1990s, the growth in Switzerland during that period was smaller, and therefore less capital expenditures were made and internal financing was sufficient. Whenever the Swiss companies needed external funds to finance their investments they relied on borrowing more than capital increases. However, it remains difficult to tell whether these decisions may be considered as a result of a POT or TOT behavior since the POT and the dynamic specification of the TOT may both

18

consider the use of debt in this case5. There is also a purely mechanical reason that can explain the lower level of debt within the framework of a dynamic TOT model. When stock prices increase due to a market boom without an increase in the size of assets nor in the value of the growth options, this will lead to a decrease of the leverage, even below the target level6.

Some institutional factors tend to lead to a high level of debt rather than a low level of debt. Hertig (1998) shows that Swiss firms have benefited from relatively easy credit during the period under study. This is because loans were often granted based more on personal relationships, than based upon objective criteria. The large banks were the first to modify their organization by splitting credit analysis from credit decisions, and by using criteria based on company expected earnings. In contrast, cantonal banks, in part due to political reasons, have been more inclined to continue granting loans based on the old system of credit, thus providing Swiss firms with relatively inexpensive financing given the risk incurred. It is difficult, however, to measure the effect of the cantonal bank behavior on the capital structure policy of listed companies as they predominantly finance non-listed SMEs. There might be some indirect effects however.

As far as corporate governance is concerned, Hertig (1998) shows that the role of large banks in Switzerland during the period under review is quite limited. For example, the stockholdings of large banks giving them more than 10% of the voting rights in industrial companies is less than 5% of their total assets (BNS, 1992-2001). One of the consequences of the passive role of bank representatives on the boards of Swiss companies, the high concentration of ownership (La Porta et al., 1998), and the lack of control in bank credit proceedings is that agency costs stemming from the conflicts of interest between lenders and borrowers are mainly borne by lenders. This will lead to an increase in the use of debt.

For the above reasons, we can conclude that being in disequilibrium due to a mechanical effect is not so costly. Two factors appear to explain the slow adjustment process of the debt level towards the target. On the one hand, there is a purely mechanical reason due to the boom
5

As the small companies have relatively more bank credit in their balance sheet than larger companies, we expect the adjustment costs to be smaller for these firms than for large firms. To test this conjecture, we divide our sample in two subsamples of small and large companies, respectively, using the median of sales to discriminate firms between both subsamples. However, we find for the small firms the same coefficient for the size variable as we do for large companies.

In this situation managers may be inclined to raise capital which would further reduce the debt level. Such behavior, however, has not been observed in our sample.

19

of the stock market that leads companies to find themselves with a lower leverage than the target. On the other hand, easy credit policy has enabled companies to borrow to finance new investments. Such firms will often have an above-target leverage. Such behavior is rational as the risk premium on bank loan interest rates is too low.

An additional result from the dynamic analysis is the coefficient of the lagged profitability variable (PROFit-1), which is positive and significant at the 1% level when total debt is considered. The impact of lagged profitability on leverage, however, is only half that of current profitability. The coefficient on lagged profitability is not significant when long term debt only is used. This result confirms a short-term pecking order behavior by Swiss firms. One possible reason could be that Swiss banks have made use of historical data when granting loans; in such a context, one would expect past profitability to play an important role. 5. Concluding Remarks

This paper presents a study of the determinants of capital structure for Swiss companies. The analyses are performed using data pertaining to 106 firms for the period 1991-2000. Both static and dynamic tests are conducted, and panel data specifications are used. The dynamic analysis is conducted using a combination of the GMM approach and instrumental variables to check for endogeneity in variables.

Our results show that the size of companies, the importance of tangible assets and business risk are positively related to leverage, while growth and current profitability are negatively associated with leverage. The dynamic analysis suggests that there exists a target debt-to equity ratio. Lagged profitability has a positive impact on leverage, which confirms the prediction of a short term pecking order behavior towards the target ratio. However, the adjustment process is shown to be very slow. We argue that the most realistic explanation is that being in disequilibrium is not costly for Swiss companies.

Once data for a longer time period are available, research should focus on the analysis of the stability of the speed of adjustment of Swiss firms towards the target debt-to-equity ratio. Also, the results contained in our paper suggest that macroeconomic events and the institutional context play an important role on the capital structure decisions of Swiss companies. It would seem appropriate that further research focus on the role played by the

20

institutional framework, such as the impact of taxation and that of the relative importance of the various sources of credit (securitized debt vs. bank debt).

From an empirical perspective, emphasis should be placed on constructing dynamic models that enable to discriminate between the various factors that impact on the target and those that impact on the speed of adjustment. Finally, focus should be placed on the ownership structure of Swiss companies to examine how firms make their financing decisions.

21

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Modigliani, F. and Miller, M.H., Corporate income taxes and the cost of capital: a correction, American Economic Review, Vol. 53, 1963, pp. 433-92. Myers, S.C., Determinants of corporate borrowing, Journal of Financial Economics, Vol. 5, 1977, pp. 147175. Myers, S.C., The capital structure puzzle, Journal of Finance, Vol. 34, 1984, pp. 575-592. Myers, S.C. and Majluf, N.S., Corporate financing and investment decisions when firms have information that investors do not have, Journal of Financial Economics, Vol.13, 1984, pp. 187-221. Ozkan, A., Determinants of capital structure and adjustment to long run target: evidence from UK company panel data, Journal of Business Finance and Accounting, Vol. 28, 2001, pp.175-199. Rajan, R.G. and Zingales, L., What do we know about capital structure? Some evidence from international data, Journal of Finance, Vol. 50, 1995, pp. 1421-60. Scott, J., Bankruptcy, secured debt, and optimal capital structure, Journal of Finance Vol. 32, 1977, pp. 1-19. Shyam-Sunder, L., and Myers S. C., Testing static tradeoff against pecking order models of capital structure, Journal of Financial Economics, Vol. 51, 1999, pp. 219-244. Smith, C.W. and Warner, J.B., On financial contracting: an analysis of bond covenants, Journal of Financial Economics, Vol. 7, 1979, pp. 117-116. Stiglitz, J. E., Some aspects of the pure theory of corporate finance: bankruptcies and takeovers, Bell Journal of Economics and Management Science, Vol. 3(2), 1972, pp. 458-482. Stulz, R., Managerial discretion and optimal financing policies, Journal of Financial Economics, Vol. 26, 1990, pp. 3-27. Taggart, R.A., A model of corporate financing decisions, Journal of Finance, Vol. 32, 1977, pp. 1467-1484. Titman, S. and Wessels, R., The determinants of capital structure choice, Journal of Finance, Vol. 43, 1988, pp. 1-19. Titman, S., The effect of capital structure on the firms liquidation decision, Journal of Financial Economics, Vol. 13, 1984, pp. 137-152. White, H., A heteroskedasticity-consistent covariance matrix estimator and a direct test for heteroskedasticity, Econometrica, Vol. 48, 1980, pp. 817-838.

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Table I: Descriptive statistics

This table presents descriptive statistics for the variables used in our estimations. The data are from Worldscope and the sample contains 106 Swiss firms listed on the Swiss stock exchange (SWX) for which we have a minimum of six consecutive years of data for the period 1991-2000. DTAB is the ratio of total debt to total assets where the total assets are measured with book values. DTAM is the ratio of total debt to total assets where the total assets is the sum of the book value of debt plus the market value of equity at the end of the year. SIZE is the natural logarithm of sales in real terms (base year = 1992). TANG is the ratio of tangible assets plus inventories to total assets using book values. GROWTH is the ratio of market value of assets (book value of assets plus market value of equity less book value of equity) to book value of assets. PROF is the ratio EBIT to total assets. RISK is the squared difference between the firms profitability (PROF) and the cross section mean of profitability for year t. To this squared measure we add the sign of the difference between the firms profitability and the cross section mean. Summary statistics include the mean and the standard deviation for years 1991, 1994, 1997, and 2000. For the total period (1991-2000), we also report the minimum and maximum. Year 1991 Mean Std DTAB 0.573 0.135 DTAM 0.569 0.186 SIZE 13.356 1.660 TANG 0.569 0.202 GROWTH 1.095 0.392 PROF 0.066 0.046 RISK 0.016 0.401 N 85 1994 Mean Std 0.575 0.153 0.518 0.196 13.523 1.611 0.571 0.188 1.245 0.500 0.077 0.056 0.053 0.783 100 1997 Mean Std 0.563 0.151 0.468 0.197 13.645 1.672 0.549 0.193 1.456 0.808 0.082 0.059 0.011 0.926 105 2000 Mean Std 0.542 0.157 0.402 0.191 13.895 1.611 0.465 0.178 1.874 1.645 0.092 0.066 0.097 1.065 86 1991-2000 Std Min 0.152 0.004 0.203 0.001 1.631 9.055 0.191 0.000 0.846 0.590 0.060 -0.257 0.908 -10.302 967

Mean 0.566 0.497 13.583 0.548 1.370 0.077 0.037

Max 0.892 0.883 18.287 0.987 11.810 0.358 7.111

24

Table II: Pearson correlation coefficients between variables and VIF coefficients
This table presents the Pearson correlation coefficients for the variables used in our estimations and VIF (variance inflation factor) tests between dependent variables. The data are from Worldscope and the sample contains 106 Swiss firms listed on the Swiss stock exchange (SWX) for which we have a minimum of six consecutive years of data for the period 1991-2000. DTAB is the ratio of total debt to total assets where the total assets are measured with book values. DTAM is the ratio of total debt to total assets where the total assets is the sum of the book value of debt plus the market value of equity at the end of the year. SIZE is the natural logarithm of sales in real terms (base year = 1992). TANG is the ratio of tangible assets plus inventories to total assets using book values. GROWTH is the ratio of market value of assets (book value of assets plus market value of equity less book value of equity) to book value of assets. PROF is the ratio EBIT to total assets. RISK is the squared difference between the firms profitability (PROF) and the cross section mean of profitability for year t. To this squared measure we add the sign of the difference between the firms profitability and the cross section mean.

DTAM DTAM DTAB SIZE TANG MTB PROF RISK

DTAB

SIZE

TANG

MTB

PROF

VIF

0.6985 -0.0113 0.2920 -0.6725 -0.6295 -0.4480

0.1533 0.0581 -0.2519 -0.4145 -0.3615

-0.3573 0.0738 0.0748 0.0305

-0.3056 -0.3200 -0.2326

0.5413 0.4155

0.8744

1.15 1.31 1.48 5.23 4.37

25

Table III: Static results

In this table we present various static estimations of the determinants of leverage. The data are from Worldscope and the sample contains 106 Swiss firms listed on the Swiss stock exchange (SWX) for which we have a minimum of six consecutive years of data for the period 1991-2000. DTAB is the ratio of total debt to total assets where the total assets are measured with book values. DTAM is the ratio of total debt to total assets where the total assets is the sum of the book value of debt plus the market value of equity at the end of the year. SIZE is the natural logarithm of sales in real terms (base year = 1992). TANG is the ratio of tangible assets plus inventories to total assets using book values. GROWTH is the ratio of market value of assets (book value of assets plus market value of equity less book value of equity) to book value of assets. PROF is the ratio EBIT to total assets. RISK is the squared difference between the firms profitability (PROF) and the cross section mean of profitability for year t. To this squared measure we add the sign of the difference between the firms profitability and the cross section mean. For the Fama-McBeth approach, we report the average of the time series of coefficients from cross sectional regressions. The models with year dummy variables and year and sector dummy variables use a dummy for each year 1992-2000 and a dummy for each sector defined by the first digit SIC code, respectively. Standard errors are reported in brackets. When appropriate, standard errors are White (1980) corrected for heteroskedasticity. *** indicates significance at the 1% level. ** indicates significance at the 5% level. * indicates significance at the 10% level. Wald 1 is a test of the joint significance of time dummy variables. Wald 2 is a test of the joint significance of sector dummy variables. Wald 1 and 2 are asymptotically distributed as 2 under the null hypothesis of no relationship. The Chow test is a F test for the equality of two sets of coefficients. The Hausman test is a test with H0: random effects are consistent and efficient, versus H1: random effects are inconsistent. Degrees of freedom are reported in brackets.

26

OLS DTAM DTAB

Fama-McBeth

DTAM

DTAB

Estimations with dummy variables for: Years Years and sectors DTAM DTAB DTAM DTAB

Panel data with: Fixed effects Random effects DTAM DTAB DTAM DTAB

Intercept

SIZE

TANG

MTB

PROF

RISK 0.598 0.210 0.588 0.210 0.595

0.652 0.445 0.718 0.410 (0.051)*** (0.053)*** (0.054)*** (0.045)*** 0.010 0.017 0.010 0.018 0.010 0.017 0.010 0.017 (0.003)*** (0.003)*** (0.002)*** (0.002)*** (0.003)*** (0.003)*** (0.003)*** (0.004)*** 0.051 -0.020 0.021 -0.019 0.047 -0.023 0.062 -0.006 (0.027)*** (0.027) (0.025) (0.021) (0.027)* (0.027) (0.028)* (0.030) -0.105 -0.009 -0.165 0.012 -0.099 -0.008 -0.099 -0.009 (0.018)*** (0.006) (0.023)*** (0.014) (0.018)*** (0.006) (0.018)*** (0.006) -2.263 -1.083 -2.054 -1.253 -2.208 -1.086 -2.122 -1.003 (0.253)*** (0.158)*** (0.144)*** (0.249)*** (0.246)*** (0.162)*** (0.241)*** (0.172)*** 0.074 0.004 0.083 0.019 0.068 0.003 0.063 0.000 (0.015)*** (0.010) (0.016)*** (0.020) (0.015)*** (0.011) (0.014)*** (0.011) 0.025 (0.009)*** 0.210 (0.034)*** -0.063 (0.005)*** -1.540 (0.125)*** 0.038 (0.007)*** 0.204 0.600 0.535 21.1(10) 7.3(10) 15.6(10) 4.7(5) 4.5(10) 2.8(5) 0.550 17.9(10) 20.3(105) 0.259 0.143 0.176 0.8(10) 19.3(105) 0.034 (0.009)*** 0.112 (0.036)*** -0.020 (0.005)*** -0.701 (0.132)*** -0.006 (0.007)

0.019 (0.005)*** 0.186 (0.029)*** -0.068 (0.005)*** -1.627 (0.123)*** 0.041 (0.007)*** 0.599 0.561 0.567 187.6(10)

0.026 (0.006)*** 0.090 (0.031)*** -0.019 (0.005)*** -0.738 (0.129)*** -0.005 (0.007) 0.258 0.154 0.188 17.05(10)

R2 ajusted

0.580

0.205

R within

R between

R overall Wald 1 Wald 2 Chow Hausman 10 10 967 967

29.7(14) 967 967 967 967 967

10.1(14) 967

967

967

27

Table IV: Dynamic results

In this table we present Arellano and Bond one-step and two-step GMM estimators. The data are from Worldscope and the sample contains 106 Swiss firms listed on the Swiss stock exchange (SWX) for which we have a minimum of six consecutive years of data for the period 1991-2000. DTAB is the ratio of total debt to total assets where the total assets are measured with book values. DTAM is the ratio of total debt to total assets where the total assets is the sum of the book value of debt plus the market value of equity at the end of the year. SIZE is the natural logarithm of sales in real terms (base year = 1992). TANG is the ratio of tangible assets plus inventories to total assets using book values. GROWTH is the ratio of market value of assets (book value of assets plus market value of equity less book value of equity) to book value of assets. PROF is the ratio EBIT to total assets. RISK is the squared difference between the firms profitability (PROF) and the cross section mean of profitability for year t. To this squared measure we add the sign of the difference between the firms profitability and the cross section mean. Robust standard deviations are reported in brackets. *** indicates significance at the 1% level. ** indicates significance at the 5% level. * indicates significance at the 10% level. Wald 1 is a test of the joint significance of time dummy variables. Wald 3 is a test of the joint significance of the estimated coefficients. Wald 1 and 3 are asymptotically distributed as 2 under the null hypothesis of no relationship. The Sargan test of over-identifying restrictions is asymptotically distributed as 2 under the null of instrument validity. The m2 test is a test for second order autocorrelation of residuals and is distributed as N(0,1). Arellano-Bond Estimator (two-step) DTAM DTit-1 SIZE TANG MTB PROF PROFit-1 RISK 0.025 (0.005)*** Wald 1 Wald 3 Sargan m2 N 164.0(8) 934.8(6) 35.7(35) 0.94 755 0.012 (0.005)** 22.8(8) 1003.7(6) 36.5(35) -1.41 755 0.609 0.066 0.119 (0.042)*** -0.092 (0.011)*** -0.989 DTAB 0.759 0.075 0.020 (0.044) 0.000 (0.004) -0.838 DTAM 0.726 0.060 0.126 (0.045)*** -0.095 (0.012)*** -0.979 0.331 0.028 DTAB 0.889 0.078 0.017 (0.046) -0.002 (0.005) -0.854 0.406 0.016 0.025 0.006 (0.009) 14.41(8) 236.7(6) 68.0(35) -1.48 755 Arellano-Bond Estimator (one-step) DTAM 0.708 0.069 0.176 (0.092)* -0.070 (0.019)*** -0.954 DTAB 0.734 0.052 (0.021)** 0.114 (0.137) -0.002 (0.009) -0.745 DTAM 0.777 0.069 (0.018)*** 0.192 (0.093)** -0.072 (0.019)*** -0.927 0.399 (0.142)*** 0.028 (0.009)*** 73.2(8) 353.9(7) 48.2(35) 1.14 755 DTAB 0.844 0.048 (0.022)** 0.138 (0.141) -0.004 (0.010) -0.736 0.451 (0.201)** 0.010 (0.010) 16.4(8) 271.6(7) 61.1(35) -1.75 755

(0.059)*** (0.045)*** (0.063)*** (0.050)*** (0.108)*** (0.101)*** (0.121)*** (0.102)*** (0.011)*** (0.013)*** (0.011)*** (0.013)*** (0.017)***

(0.126)*** (0.098)*** (0.118)*** (0.105)*** (0.196)*** (0.154)*** (0.194)*** (0.166)*** (0.074)*** (0.063)*** (0.005)*** (0.006)*** (0.008)*** 151.6(8) 952.5(7) 38.0 (35) 1.22 755 25.6(8) 1015.7(7) 32.2 (35) -1.59 755 73.5(8) 342.1(6) 48.9(35) 0.83 755

28