The determinants of corporate debt maturity structure: evidence from Czech firms

by Pavel Krner

Content
Motivation Theories of debt maturity structure Agency costs theories Signalling and liquidity risk Maturity matching Taxes Dependant variable Explanatory variables and hypotheses What was not included Data Limitations and open issues

Motivation
how do the firms really decide on the financing (tools, maturities, counterparties), which includes debt vs. equity, short term vs. long term decision making limited empirical evidence abroad, no Czech empirical evidence,

Agency costs theories 1

Growth options corporate future investment opportunities can be considered as options, value of these options depends on the probability that they will be exercised optimally, the profits of these investments are split among shareholders and debtholders accordingly, in some cases the debtholders may capture too much high share of the profit leaving below-normal returns to shareholders which may create incentive problems for shareholders, in this particular case the shareholders are keen to reject investment with net present value (underinvestment problem), the maturity of debt can play important role, firms can issue more short term debt which matures and can be re-contracted before the growth options can be exercised,

Agency costs theories 2

Size larger firms have lower agency costs, larger firms are believed to have easier access to capital markets and stronger negotiation power, both these arguments favor larger firms for issuing more long-term debt compared to smaller firms Collateralizable assets the volume of collateralizable assets (e.g. assets that can be pledged in favor of the creditor such as inventory or premises) in the companys balance sheet is believed to have impact on the debt maturity structure, firms with more collateralizable assets can employ them to be pledged for long-term debts which favors them compared to firms with less collateralizable assets, thus the firms with less collateralizable assets are believed to have less long-term debt and more short-term debt,

Signalling and liquidity risk 1

Signalling quality corporate debt maturity structure is related to the degree of asymmetric information between insiders and outsiders (investors), it can be signalling tool of more informed insiders to less informed outsiders about the firms quality, low-quality firms prefer more long-term debt and high-quality firm prefer more short term debt, in transaction costs environment the low-quality firm can not afford to roll-over the short term debt as they are facing considerable risk of financial distress in case the debt shall not be prolonged, high-quality firms will issue more short-term debt than low-quality firms, the managers of the high-quality firms voluntarily expose the firms to the risk of debt renegotiation after more information to outsiders shall be available as they expect these information to be positive, as a result, high-quality firms signal their type by issuing short-term debt,

Signalling and liquidity risk 2

Leverage Leland and Toft (1996) show theoretically that firms with higher leverage tend to choose longer maturity of the debt and vice versa, Morris (1992) argues that firms with higher debt ratio tend to issue more long term debts in order to delay their exposure to bankruptcy risk, on the other side the tax and agency theories predict opposite effects of leverage on debt maturity, therefore the impact of the leverage on the debt maturity structure is an empirical puzzle,

Maturity matching
Maturity matching is as liquidity immunization of the balance sheet structure, the company can face risk of not having sufficient cash if the debt maturity is shorter than that of assets (the debt service is shorter than the asset life cycle e.g. ability to produce cash flow) or even vice versa if the maturity of the debt is longer than that of assets (cash flow from assets necessary for debt repayment terminate), can partially serve as a tool for mitigation of underinvestment problem, here it ensures that the debt repayments shall be due accordingly to decline of asset value, has two strategies namely accounting and financing approach, the accounting approach considers assets as current and fixed ones and calls for financing of current assets by short-term liabilities and of fixed assets by long-term liabilities and equity, the financing approach considers assets as permanent and temporary, in these terms fixed assets are definitely permanent ones and also some stable part of fluctuating current assets is taken as permanent, as a consequence it employs ceteris paribus more long-term liabilities, the financing approach (borrowing on more long-term basis) brings more stable interest costs than the accounting approach but as the yield curve is usually upward sloped, the finance approach is also more costly,
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Taxes
Taxes debt maturity structure prolongs with increasing flotation costs (debt transaction costs); the higher the transaction costs associated with a debt issue, the grater is the optimal maturity of the debt, since more time is required to amortize the flotation costs, debt maturity structure prolongs with decreasing corporate debt tax shield; high personal tax rate is generally associated with higher optimal maturity, at a lower tax advantage, a longer maturity is required to amortize the flotation costs incurred in issuing the debt. At very high personal tax rates, it becomes optimal for the firm to issue no debt because the tax advantage net of bankruptcy costs is never great enough to offset amortized transactions costs, whatever the maturity debt maturity structure prolongs with decreasing volatility of the firm value reflecting the fact that with less volatile asset returns, the firm rebalances its capital structure less frequently,

Dependant variable
Debt maturity structure is usually depicted as a share of long-term debt to total debt, the long-term debt is considered either as debt maturing over one year or as a debt maturing over longer period (mostly five years), in Czech case the share of debt maturing over one year to total debt is employed, first, there are no data enabling to differentiate the particular maturities of the long-term debt, second, in the Czech financial system the creditors are not much keen to finance on longer than five years maturity basis, third, the financial practitioners pay less attention to the particular maturities of the long-term debt than to the short-term debt vs. long term debt decision making

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Explanatory variables 1
Growth options Hypothesis 1: Firms with more growth options have shorter debt maturity structure one approach is to compare the market value and book value of the assets which is driven by the argument that the companies with positive expectations from the financial market is to have more growth options. As a consequence the difference of the market value and book value of its assets shall be higher than it is the case for company with negative financial market expectations. Naturally, this approach is not employable for the Czech firms, as the market value is known only for very limited set of companies (bank based financial system), the second approach considers development of fixed assets as a proxy for the growth options, here investments into fixed assets are considered as a signal for the market that the company is increasing its capacity and thus has positive future expectations, this can be depicted by either share of annual depreciation to total assets (if this increases, the company has invested into fixed assets), or by relation of annual capital expenditures (CAPEX) to total assets which is a proxy more rapidly mirroring the changes of fixed assets,

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Explanatory variables 2
Size Hypothesis 2: Larger firms have longer debt maturity structure, size of the company can be measured either in terms of the volume of production (revenues in fixed prices), or in terms of the volume of property (total assets), the impact of the size is expected to be lower for larger firms, usually natural logarithm of the proxy for the size is used, Collateralizable assets Hypothesis 3: Firms with more collateralizable assets have longer debt maturity structure, intangible assets (such as goodwill or licenses) are not easily collateralizable whereas tangible assets (such as inventory or premises) are collateralizable, therefore share of tangible assets (excluding financial fixed assets) on total assets serves as a proxy for collateralizable assets, collateralizable assets shall be probably also excluding current tangible assets,

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Explanatory variables 3
Signalling quality Hypothesis 4: Low-quality firm have longer debt maturity structure and high-quality firm have shorter debt maturity structure, abnormal future earnings serves as a proxy for firm quality, this is followed either as earnings per share difference in two years scaled by share price, or as revenues difference in two years scaled by the revenues, the revenues are employed in our case as the volume of revenues seems to be intuitively better proxy, there is lack of data on share volumes of particular companies, there are also other types of corporations than joint stock companies (for which EPS can not be computed anyway) Leverage Hypothesis 5: Firms with higher leverage have longer debt maturity structure. the leverage can be measured either fully in book values as a share of total debts on total assets or in a mixture of book and market values as a share of total debts on total debts plus market value of equity, 13 naturally, in our case the prior proxy is employed,

Explanatory variables 4
Maturity matching Hypothesis 6: Firms with longer asset maturity have longer debt maturity structure, the impact of maturity matching can be also measured twofold, first measure considers the share of the long-term funded assets on total assets, it takes into account the whole volume of the funded assets but disregards its true particular maturities (some assets are utilized for longer time than others), the second measure interprets the assets maturity in terms of time (PPE/annual depreciation), this takes on the other side into account the true particular maturity of property, plant and equipment but again, it disregards the impact of other fixed assets such as intangible fixed assets (licenses) or financial fixed assets (subsidiaries) which are also said to be funded on long-term basis,

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Explanatory variables 5
Taxes Hypothesis 7: Firms with higher effective income tax rate have longer debt maturity structure, the effective income tax rate is usually measured as ratio of taxes paid to pre-tax income, hence the impact of deferred taxes is omitted, Firm value volatility Hypothesis 8: Firms with less volatile asset returns have longer debt maturity structure, the general proxy for firm value volatility is taken as earnings volatility, usually the variance of EBITDA scaled by total assets is considered as appropriate variable,

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What was not included 1

Business risk smaller firms are believed to loose creditworthiness more quickly which increases the agency costs of their risks, therefore the agency costs theory suggests that borrowers in more risky businesses shall favor more short term debt, Hypothesis: Firms operating on more risky markets have shorter debt maturity structure, no available proxy

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What was not included 2

Liquidity risk the liquidity risk or financial distress risk provides strong incentives for firms to borrow on long-term basis, short-term debt allows for renegotiation of debt costs after good news about the company are released, on the other side the short-term debt represents liquidity risk for the debtor which would arise if the short-term debt would not be renegotiated, thus a typical trade-off relationship arises, low-quality debtors with low cash-flows for long-term debt repayments are forced to borrow on short-term basis; middle-quality debtors favor long-term financing since they face higher liquidity risk than the high-quality debtors; and high-quality debtors who face low liquidity risk favor short-term borrowing, at the end there are two types of borrowers on short term basis: those of high-quality and those of low-quality whereas firms in between of middle-quality are expected to borrow on long-term basis, Hypothesis: Low-quality firm and high-quality firm have shorter debt maturity structure and middle-quality firm have longer debt maturity structure, the proxy generally used is credit rating, which is not available in our case,
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Data
data are from EKIA, these include financial statements (differing detailed structure) of huge amount of companies of differing state from different sectors for several years, some need to be eliminated due to lack of necessary data (financial statements reallocations), presence in bankruptcy, impropriate sector (only non-financial intermediary companies are considered), limited years typical panel data (companies and time) OLS to be employed

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Limitations and open issues

Limitations limited explanatory power of the determinants, limited explanatory power of the variables (determinants { proxies, accounting issues such as omitted off-B/S items), determinants are of the same priorities but in reality the decision making has some priorities and starting points, no considerations of cash in the determinants (cash-poor and cash-rich companies), no market value data, no credit ratings data, no flotation costs data, Open issues what is the true sequencing in the decision making on financing (debt vs equity, maturity, tool, counterparty or all at once), To be continued capital structure (debt vs. equity) on the same data, opinion survey among CFO,
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