Joshua Abor and Nicholas Biekpe University of Stellenbosch, Graduate School of Business

ABSTRACT This paper seeks to empirically identify the determinants of the capital structure of listed firms on the Ghana Stock Exchange during the most recent six-year period. Ordinary Least Square model is used to estimate the regression equation. The results indicate that, total debt constitutes more than half of the capital of listed firms in Ghana. The results also show positive associations between debt ratio (capital structure) and firm size and growth, while asset tangibility, risk, corporate tax and profitability are negatively related to debt ratio. The results generally support the pecking order theory proposed by the theoretical model.

The capital structure of a firm is actually a specific mixture of debt and equity a firm employs in financing its operation. The capital structure decision is crucial for any business organization. The decision is important because of the need to maximize returns to various organizational constituencies, and also because of the impact such a decision has on an organization’s ability to deal with its competitive environment. In an attempt to set a capital structure that maximizes overall market value, firms do differ with regard to their capital structure. That is why there are various theories of capital structure that try to explain this cross-sectional variation. Keywords: capital structure, leverage, debt ratio, Ghana JEL Classification: G3, G32

Correspondence to Joshua Abor joshabor@ug.edu.gh

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These theories examine the determinants of capital structure from different aspects and come out with different conclusion as far as the choice of the determination of the level of financial leverage is concerned. Empirical evidence, focusing mainly on developed economies has also provided inconclusive results on the issue. It is important to examine capital structure from the perspective of developing countries given the differences in levels of economic development. This present study investigates the determinants of capital structure of listed firms on the Ghana Stock Exchange (GSE) during the most recent six-year period (1998 – 2003). The subject matter is an area that has not yet been explored in Ghanaian finance literature. The paper is organized as follows. The next section gives a review of the extant theoretical and empirical literature on the determinants of capital structure. Section three explains the methodology adopted for the study. The empirical results are presented and discussed in section four. Finally, section five summarizes the findings of the research and also concludes the discussion.

A number of important theories have been advanced to explain the capital structure of firms. These include tax benefits associated with debt use, the agency theory, bankruptcy cost, the pecking order theory and the signaling theory. The tax benefits associated with debt use, bankruptcy cost and the agency theory are described in terms of the static trade off theory. These theories are discussed in turn. Corporate taxes allow firms to deduct interest on debt in computing taxable profits. This suggests that tax advantages derived from debt would lead firms to be completely financed through debt. This benefit is created, as the interest payments associated with debt are tax deductible, while payments associated with equity, such as dividends are not tax deductible. Therefore, this tax effect encourages debt use by the firm, as more debt increases the after tax proceeds to the owners (Modigliani & Miller, 1963; Miller, 1977). Bankruptcy costs are the cost directly incurred when the perceived probability that the firm will default on financing is greater than zero. The bankruptcy probability increases with debt level since it increases the fear that the company might not be able to generate profits to pay back the interest and the loans. The potential costs of bankruptcy may be both direct and indirect. Examples of direct bankruptcy costs are the legal and administrative costs in the bankruptcy process. Haugen and Senbet (1978) argue that bankruptcy costs must be trivial or nonexistent if one assumes that capital market prices are competitively determined by rational investors. Examples of indirect bankruptcy costs are the loss in profits incurred by the firm as a result of the unwillingness of stakeholders to do business with them (Titman, 1984). The use of debt in capital structure of the firm also leads to agency costs. Agency costs arise as a result of the relationships between shareholders and managers and those between debtholders and shareholders (Jensen & Meckling, 1976). According to Harris and Raviv (1990), the conflict between shareholders and managers arises because shareholders hold the entire residual claim and consequently managers do not capture the entire gain from their profitenhancing activities but they do bear the entire cost of these activities. Separation of ownership and control may result in managers exerting insufficient work, indulging in perquisites, choosing inputs and outputs that suit their own preferences. On the other hand, the conflict between debt-holders and shareholders is due to moral hazard.


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The conflict arises because equity-holders have an incentive to invest suboptimally in very risky projects (Jensen and Meckling, 1976). In the event of an investment yielding large returns, equity-holders receive the majority of the benefits. However, in the case of the investment failing, debt-holders bear the majority of the consequences (Brander & Lewis, 1986). The need to balance gains and costs of debt financing emerged as a theory known as the static trade-off theory by Myers (1984). It values the company as the value of the firm if unlevered plus the present value of the tax shield minus the present value of bankruptcy and agency costs. The concept of optimal capital structure is also expressed by Myers (1984) and Myers and Majluf (1984) based on the notion of asymmetric information. The conclusion drawn from the asymmetric information theories is that, there is a hierarchy of firms’ preferences with respect to the financing of their investments (Myers and Majluf, 1984). This “pecking order” theory suggests that firms will initially rely on internally generated funds, i.e. undistributed earnings, where there is no existence of information asymmetry, then they will turn to debt if additional funds are needed and finally they will issue equity to cover any remaining capital requirements. The order of preferences reflects the relative costs of various financing options. Myers and Majluf (1984) maintain that, firms would prefer internal sources to costly external finance. Firms that are profitable or generate high earnings are therefore expected to use less debt capital than those that do not generate high earnings The pecking order theory would indicate that the profitability of a firm affects its financing decisions. If it issues debt, this means that the firm has an investment opportunity that exceeds its internally generated funds. So, changes in the capital structure often serves as a signal to outsiders about the current situation of the firm as well as the managerial expectations concerning future earnings. This is called the signalling theory. The debt offering is believed to reveal information the management of a firm is expecting about future cash flows if it will cover the debt costs. However, the bankruptcy fears still impact the signal and intensify the cost of this signal (Asquith and Mullins, 1986; and Eckbo, 1986).

2.1 Capital Structure and Firm Characteristics
A number of firm-level characteristics have been identified in previous empirical studies examining capital structure and these include; firm size, asset structure, profitability, risk, growth and corporate tax. These are discussed in turn.

2.1.1 Firm Size
Size has been viewed as a determinant of a firm’s capital structure. Larger firms tend to be more diversified and hence have lower variance of earnings, making them able to tolerate high debt ratios (Castanias, 1983; Titman and Wessels, 1988; Wald, 1999). Smaller firms on the other hand may find it relatively more costly to resolve information asymmetries with lenders, thus, may present lower debt ratios (Castanias, 1983). Another explanation for smaller firms having lower debt ratio is if the relative bankruptcy costs are an inverse function of firm size (Titman and Wessels, 1988). This view is also explained differently by Castanias (1983). He states that if the fixed portion of default costs tends to be large, then marginal default cost per dollar of debt may be lower and increase more slowly for larger firms.

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Empirical evidence on the relationship between size and capital structure of firms are quite varying with respect to conclusions. Several works support a positive relationship between firm size and leverage (Marsh, 1982; Friend and Lang 1988; Barton et al, 1989; Rajan and Zingales, 1995; Cassar and Holmes, 2003, Al-Sakran, 2001, Hovakimian et al, 2004). Fischer et al (1989) however found a negative relationship between size and debt ratio.

2.1.2 Asset Tangibility
The asset tangibility of a firm plays a significant role in determining its capital structure. The degree to which the firm’s assets are tangible should result in the firm having greater liquidation value (Harris and Raviv, 1991; Titman and Wessels, 1988). Bradley et al (1984) assert that firms that invest heavily in tangible assets tend to have higher financial leverage since they borrow at lower interest rates if their debt is secured with such assets. It is believed that, debt may be more readily used if there are durable assets to serve as collateral (Wedig et al, 1988). By pledging the firm’s assets as collateral, the cost associated with adverse selection and moral hazards are reduced. This will result in firms with assets that have greater liquidation value having relatively easier access to finance at lower cost, consequently, leading to higher debt or outside financing in their capital structure. Empirical evidence suggests a positive relationship consistent with theoretical argument between asset structure and leverage for large firms (Bradley et al, 1984; Wedig et al, 1988; Friend and Lang 1988; Mackie-Mason, 1990; Rajan and Zingles 1995; Shyam-Sunder and Myers 1999; Hovakimian et al, 2004). Kim and Sorensen (1986) however found a significant and negative coefficient between depreciation expense as a percentage of total assets and financial leverage.

2.1.3 Profitability
The relationship between firm profitability and capital structure can be explained in terms of the pecking order theory. According to this theory, firms prefer internal sources of finance to external sources. The order of the preference is from the one which is least sensitive (and least risky) to the one which is most sensitive (and most risky) that arise because of asymmetric information between corporate insiders and less well-informed market participants (Myers 1984). By this token, profitable firms, which have access to retained profits, can rely on it as opposed to depending on outside sources (debt). Titman and Wessels (1988) and Barton et al (1989), agree that firms with high profit rates, all things being equal, would maintain relatively lower debt ratio since they are able to generate such funds from internal sources. Empirical evidence from previous studies seems to be consistent with the pecking order theory. Most studies found a negative relationship between profitability and capital structure (Friend and Lang, 1988; Barton et al, 1989; Shydam-Sunder and Myers, 1999; Jordan et al, 1998; Mishra and Mc Conanghy, 1999, Al-Sakran, 2001; Hovakimian et al, 2004).

2.1.4 Firm Risk
The level of risk is said to be one of the primary determinants of a firm’s capital structure (Kale et al, 1991). The tax shelter-bankruptcy cost theory of capital structure determines a firm’s optimal leverage as a function of business risk (Castanias, 1983). Given agency and bankruptcy costs, there are incentives for the firm not to fully utilize the tax benefits of 100% debt within a static framework model. The more likely a firm will be exposed to such costs, the greater their incentive to reduce their level of debt within the capital structure of the firm.


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One firm variable which impacts upon this exposure is the firm’s operating risk, in that, the more volatile the firm’s earnings stream, the greater the chance of the firm defaulting and being exposed to such costs. According to Johnson (1997), firms with more volatile earnings growth may experience more states where cash flows are too low for debt service. Kim and Sorensen (1986) also observed that, firms with high degree of business risk have less capacity to sustain financial risks and thus, use less debt. A number of works have indicated an inverse relationship between risk and debt ratio (Kale et al, 1991; Bradley et al, 1984; Titman and Wessel, 1988; Friend and Lang 1988; Mackie-Mason 1990; Kim et al, 1998).

2.1.5 Growth
The relationship between growth and capital structure can also be explained by the pecking order hypothesis. Growing firms place a greater demand on the internally generated funds of the firm. According to Marsh (1982), firms with high growth will capture relatively higher debt ratios. There is also a relationship between the degree of previous growth and future growth. Michaelas et al (1999) argue that future opportunities will be positively related to leverage, in particular short term leverage. They argue that agency problem and consequentially the cost of financing are reduced if the firm issues short term rather than long-term debt. Myers (1977) however, holds that view that firms with growth opportunities will have smaller proportion of debt in their capital structure. This is due to the fact that, conflicts between debt and equity holders are especially serious for assets that give the firm the option to under take such growth opportunities in the future. Empirical evidence seems inconclusive. Some researchers found positive relationship between sales growth and leverage. (Kester, 1986; Titman and Wessels, 1988; Barton et al, 1989). Other evidence showed that higher growth firms use less debt, as such indicated negative relationship between growth and debt ratio (Kim and Sorensen, 1986; Stulz, 1990; Rajan and Zingales, 1995; Mehran, 1992; Roden and Lewellen, 1995; Al-Sakran, 2001).

2.1.6 Taxation
There have been numerous empirical studies of the impact of taxation on corporate financing decisions in the major industrial countries. Some are concerned directly with tax policy, for example: Auerbach (1984), Mackie-Mason (1990), Shum (1996), and Graham (1996, 1999). MacKie-Mason (1990) studied the tax effect on corporate financing decisions. The study provided evidence of substantial tax effect on the choice between debt and equity. He concluded that changes in the marginal tax rate for any firm should affect financing decisions. When already exhausted (with loss carry forwards) or with a high probability of facing a zero tax rate, a firm with high tax shield is less likely to finance with debt. The reason is that tax shields lower the effective marginal tax rate on interest deduction. Graham (2002) concluded that, in general, taxes do affect corporate financial decisions, but the magnitude of the effect is mostly “not large”. On the other hand, DeAngelo and Masulis (1980) show that there are other alternative tax shields such as depreciation, research and development expenses, investment deductions, etc., that could substitute the fiscal role of debt. Empirically, this substitution effect is difficult to measure as finding an accurate proxy for tax reduction that excludes the effect of economic depreciation and expenses is tedious (Titman and Wessels, 1998).

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This study sampled all firms that have been listed on the GSE over the recent six year period (1998-2003). Twenty two firms qualified to be included in the study sample. All the companies that were included in the sample fulfil two basic criteria. First, all of the firms were listed on the GSE as at 1997. Secondly, none of the sample firms was delisted during the period under investigation. The data used in the empirical analysis was derived from the annual reports of the firms during the period 1998-2003. With respect to the variables used in the analysis, the capital structure or debt ratio, which is the dependent variable, is defined as the ratio of total debt divided by the total capital. Total debt contains both long-term and short-term debts. The strict notion of capital structure refers exclusively to long-term leverage. However, firms in Ghana use either very little or no longterm capital, mainly because of the difficulty in obtaining long-term financing from the banking sector with attractive terms. As a result, they mostly turn to short-term borrowing to finance their long-term projects. Thus, debt includes both long-term and short-term debt financing. The explanatory variables include size, asset tangibility, profitability, risk, growth and corporate tax. The debt ratio is regressed against the six explanatory variables. The panel character of the data allows for the use of panel data methodology. Panel data involves the pooling of observations on a cross-section of units over several time periods and provides results that are simply not detectable in pure cross-sections or pure time-series studies. The panel regression equation differs from a regular time-series or cross section regression by the double subscript attached to each variable. The general form of the panel data model can be specified more compactly as:

Yit = α i + β X it + ë it


with the subscript i denoting the cross-sectional dimension and t representing the time-series dimension. The left-hand variable Yit , represents the dependent variable in the model, which is the firm's debt ratio. X it contains the set of explanatory variables in the estimation model, is taken to be constant overtime t and specific to the individual cross-sectional unit i. If



taken to be same across units, Ordinary Least Squares (OLS) provides a consistent and efficient estimate of α and β . The model for estimating the determinants of capital structure based on the variables discussed in section 2.1 is therefore given as follows:

DRit = β 0 + β1 SIZEit + β 2TANGit + β 3 ROAit + β 4 RISK it + β 5 GROWit + β 6TAX it + ë it


DRit = leverage (total debt/ equity + debt) for firm i in time t

SIZEit = the size of the firm (log of total assets) for firm i in time t TANGit = fixed tangible assets divided by total assets for firm i in time t ROAit = earnings before interest and taxes divided by total assets for firm i in time t RISK it = the squared difference between the firm’s profitability in time t and the mean
profitability for firm i,


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GROWit = growth in sales for firm i in time t

TAXit = the ratio of tax paid to operating income for firm i in time t ë = the error term
4. EMPIRICAL RESULTS 4.1 Summary Statistics
Table 1 provides a summary of the descriptive statistics of the dependent and independent variables. This shows the average indicators of variables computed from the financial statements. The mean (median) debt ratio (measured by total debt /total capital) of the sample firms was 0.5850 (0.5443). Total debt appears to constitute more than half of the capital of the firms. This suggests that, 58.5% of total assets are financed by debt capital. Equity capital therefore represents 41.5%. Size, determined as the natural logarithm of total assets had a mean (median) of 18.3286 (18.0726). Asset tangibility had a mean of 0.3834. This indicates that, on average, fixed assets accounted for 38.34% of total assets. Profitability, given as the ratio of EBIT to total assets, registered a mean value of 0.1156 suggesting a return on assets of 11.56%. Risk is measured as the variability of EBIT and this showed a mean (median) of 0.9097 (0.6472). The mean growth (measured as growth in sales) was 0.3252. This indicates that, on average, growth rate in sales was 32.52% during the six-year period. Corporate tax rate on average was 23.27%. Table 1: Descriptive statistics of dependent and independent variables
Mean DR SIZE TANG ROA RISK GROW TAX 0.5850 18.3286 0.3834 0.1156 0.9097 0.3252 0.2327 Std. Dev. 0.2006 1.9179 0.2268 0.1125 4.5442 0.3463 0.1609 Minimum 0.1787 14.5760 0.0177 -0.1408 -22.7185 -0.7500 0.0000 Median 0.5443 18.0726 0.4124 0.0993 0.6472 0.2553 0.2695 Maximum 1.1018 22.6666 0.9650 0.5415 22.3320 1.3597 0.5794

4.2 Regression Analysis
Regression analysis is used to investigate the relationship between the firm-level variables and leverage. Ordinary Least Square (OLS) regression results are presented in Table 2. The results indicate a statistically significant positive relationship between size and leverage. The results suggest that the bigger the firm, the more debt it will use. One reason is that, larger firms are more diversified and hence have lower variance of earnings, making them able to tolerate high debt ratios. Lenders are more willing to lend to larger companies because they are perceived to have lower risk levels. On the other hand, smaller firms may find it relatively more costly to resolve information asymmetries with lenders, thus, may present lower debt ratios. This result is expected from financial theory. The coefficient of asset tangibility variable is negative and significant for the panel data estimations. The results suggest that, for Ghanaian firms, a higher proportion of fixed assets lead to the use of less debt financing in relative terms.

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A plausible reason is that higher proportions of fixed assets denote higher operating risks therefore firms may not want to be exposed to more risk from the use of more debt capital. Alternatively, a higher proportion of fixed assets would also suggest that a company has the required capital which may qualify it to get listed on the stock market. Since listing requirements on the Ghanaian Stock Exchange include stated capital this is likely to influence the choice of equity over debt. The regression coefficient for the effect of profitability on leverage is negative and highly statistically significant. The results, which are also consistent with previous studies show that, higher profits increase the level of internal financing. Firms that generate internal funds, generally tend to avoid gearing (debt). While profitable firms may have better access to debt finance than less profitable ones, the need for debt finance may possibly be lower for highly profitable firms if the retained earnings are sufficient to fund new investments. The findings clearly provide support for the pecking order theory that denotes that profitable firms prefer internal financing to external financing. The negative impact of risk for the OLS estimation implies that, firms which perform below average are less leveraged. In other words, companies with high operating risk try to control total risk by limiting financial risk which is associated with debt financing. Firms with high degree of business risk have less capacity to sustain financial risks and thus, use less debt. High risk firms are also said to have low cash flow for debt service. The results show a positive sign of growth. The sample of listed firms in this study suggests that growth is associated in a direct manner with financial leverage. If this is generally the case, then firms with high growth will require more external financing to finance their growth and should therefore display higher leverage. This view is supported by previous empirical studies (Kester, 1986; Titman and Wessels, 1988; Barton et al, 1989). The empirical results in this study also show a negative relationship between corporate tax and capital structure. In Ghana, the relationship could be attributable to the special tax rebate for listed firms. Firms that go public tend to enjoy tax reduction compared to unlisted firms. Companies have an incentive to get listed given the tax incentive they receive. Thus, a general increase in corporate tax would be associated with increasing equity capital since firms would be encouraged to go public and enjoy the special tax rebate. This position appears to be contrary to traditional capital structure theory but may be reasonable in the Ghanaian context. Table 2: Regression Model Results
Variable SIZE TANG ROA RISK GROW TAX R-squared S.E. of regression F-statistic Prob(F-statistics) Coefficient 0.0202 -0.6057 -0.5696 -0.0022 0.0143 -0.0941 0.986828 0.127475 1248.6490 0.000000 t-Statistic 5.5278 -20.6096 -7.4059 -3.6064 1.9666 -3.1576 Prob. 0.0000 0.0000 0.0000 0.0005 0.0520 0.0021


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This paper presents a study of the determinants of capital structure of listed firms in Ghana. The analyses are performed using data derived from the financial statements listed firms on the GSE during the most recent six-year period. Ordinary Least Square model is used to estimate the regression equation. The results indicate that, total debt constitutes about 59% of the total capital of listed firms in Ghana. The results also show that the capital structure of the firms studied is positively related to firm size and growth. The analysis suggests that, larger firms employ more debt capital in comparison with smaller firms. Also, firms with high growth require more external financing to finance their growth and therefore display higher leverage. Asset tangibility, risk, corporate tax and profitability also have negative impacts on leverage. The peculiar negative relationship between asset tangibility and capital structure suggests that higher proportion of fixed assets leads to the use of less debt financing. The results also indicate that firms with high degree of business risk have less capacity to sustain financial risk which is associated with debt financing and thus, use less debt. The negative relationship between corporate tax and capital structure could be attributed the special tax rebate listed firms in Ghana enjoy. Companies therefore have an incentive to get listed given the tax incentive they receive. The negative association between profitability and leverage also suggests that, firms with high profitability tend to use less debt. This finding is consistent with the activities following the financing procedure implied by the pecking order theory. High profitable firms generate high internal cash flows to finance their investment. The results of this study generally support the pecking order argument proposed by the theoretical model.

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