FOREIGN TRADE UNIVERSITY FACULTY OF BANKING AND FINANCE GRADUATION THESIS Major: Banking and International Finance IN VIETNAM CAPITAL STRUCTURE AND FIRM PERFORMANCE IN VIETNAM Student’s Full Name: Duong Hong Ngoc Student ID: 0953040063 Intake: 48 – A3 – CLC Table of Contents Table of Figures Figure1. 1 How leverage magnies both risk and return of a firm Table 1.2 Summary of popular capital structure theories Figure 1.3 M&M Proposition I: Two Pie models of capital structure 1 FOREIGN TRADE UNIVERSITY FACULTY OF BANKING AND FINANCE GRADUATION THESIS Major: Banking and International Finance CAPITAL STRUCTURE AND FIRM PERFORMANCE IN VIETNAM Student’s Full Name: Duong Hong Ngoc Student ID: 0953040063 Intake: 48 – A3 – CLC Supervisor: Duong Thi Hong Van, MSc. Hanoi, June 2013 Hanoi, May 2012 Figure 1.4 The Cost of Equity and the WACC: M&M Figure 1.5 M&M Proposition I with taxes Figure 1.6 M&M Proposition II with taxes Figure 1.7 The Static Theory of capital structure: Optimal capital structure and the cost of capital Figure 1.8 The Static Theory of capital structure: Optimal capital structure and thevalue of a firm Figure 2.1 GDP growth rate of Vietnam from 2008 to 2012 Figure 2.2 Monthly inflation rate of Vietnam from Jan 2010 to Mar 2013 Figure 2.3 Interest Rates of Vietnam from Jun 2010 to Apr 2013 Figure 2.4 Growth rate of newly listed companies in Vietnam from 2008 to 2012 Figure 2. 5 Vietnam’s Bond Market since 2000 to 2011 (% GDP) Figure 2. 6 Comparison of Vietnamese capital structure with those of other countries Introduction There are three basic questions that all financial management decisions of a firm are concerened with. They are caputal budgeting, capital structure and working capital questions. While capital budgeting decision concern with the planning and managing of a firm’s long- term investment, capital structure decisions involve figuring out how to finance these investment in the most efficient way. As capital structure plays an important role in a firm’s well-being, it must have a certain kind of relationship with firm performance. If we are able to find out what the relationship is, firms will have a stronger support for managing the firm financially. As for the Government, it will be able to come up with proper policies to make ways for firm to improve their performance. As for banks, they will be able to know more about the firm’s performance through its capital structure, therefore avoid information assymetry problem. There are numerous of research on the subject of capital structure. The pioneer theory is Modigliani and Miller propositions, developed in 1958. After that, other theories have come out like the static tradeoff theorywhich was developed by Bradley et al. in 1984, pecking order theory which was proposed by Myers and Majluf (1984) and the agency cost theory which was developed by Jensen and Meckling in 1976. On a globel scale, many studies have been conducted to find out the relationship betwwen capital structure and firm performance. Among them are studies conducted by Wei Xu et al. in 2005 on Chinese companies, Zeitun and Tian in 2007 on Jordanian companies and Margaritis and Psillaki in 2010 on New Zealander companies. Although there are many research on the relationhsip betwwen capital structure and firm performance in the wrold, there are only few research on this relationship in Vietnam. That is the reason why the author chooses the topic “Capital Structure and Firm Performance in Vietnam” as the topic of the graduation thesis. The objective of this research is to find out what are the determinants of both accounting and market firm performace in addtion to capital structure and which relationship each determinant has on firm performace. Based on the results, the writer proposes some solutions 2 to both companies and the authority to help firms improve their performance through proper decisions. The subjects of this research are determinants of firm performance, namely leverage, size and growth. Leverage is measured by total debt/total asset, short-term debt/total asset and long- term debt/total asset. Size is measured by the natural logarithm of sales. Growth is measured by the growth rate of sales. The scope of this research is 233 companies listed on Hanoi Stock Exchange (HNX) and Ho Chi Minh Stock Exchange (HOSE) in the period of 2008-2011. The methodology of this research is: The method of collecting data is gathering secondary data from listed companies’ financial statements from 2008 to 2011. The method of processing data is based on panel estimation models, which are fixed effects model (FEM) and random effect model (REM). The structure of this research is: Chapter 1: Backgrounds on Capital Structure and Firm Performance Chapter 2: Analysis of the relationship between capital structure and firm performance Chapter III. Implications and Recommendations to improve firm performance based on capital structure policy Hanoi, June 2013 Writer Duong Hong Ngoc CHAPTER I Backgrounds on capital structure and firm performance 1.1. Firm’s capital and capital structure 1.1.1. Cost of capital For each project that a company invests in, the appropriate discount rate on a new project is the minimum expected rate of return an investment must offer to be attractive. This minimum required return is often called the cost of capital associated with the investment. It is called this because the required return is what the firm must earn on its capital investment in a project just to break even. It can thus be interpreted as the opportunity cost associated with the firm’s capital investment. 1 (Ross et al., 2003). For the company as a whole, its cost of capital is defined as the expected return on a portfolio of all the company’s existing securities. It is used to discount the cash flows on projects that have similar risk to that of the firm as a whole. 2 (Brealey−Meyers, 2003). This cost of capital is refered to as WACC (Weighted avaerage cost of capital). In discussing the WACC, we will learn that a firm will normally raise capital in a variety of forms and that these different forms of capital may have different costs associated with them. These forms of capital are equity, debt and prefered stock. 1 Ross et al., 2003: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition, McGraw-Hill, P.442 2 Brealey−Meyers, 2003: Principles of Corporate Finance, Seventh Edition, McGraw-Hill, P.222 3 1.1.1.1. Cost of equity This section discusses two approaches to determining the cost of equity: the dividend growth model approach and the security market line, SML, approach. a. The Dividend Growth Model Approach The easiest way to estimate the cost of equity capital is to use the dividend growth model. Under the assumption that the firm’s dividend will grow at a constant rate g, the price per share of the stock, P 0 , can be written as: P 0 = D 0 ∗(1+ g) R E − g = D 1 R E −g where D 0 is the dividend just paid and D 1 is the next period’s projected dividend. Notice that we have used the symbol R E (the E stands for equity) for the required return on the stock. To calculate g, we might observe dividends for the previous, say, five years, calculate the year-to- year growth rates, and average them. We can rearrange the above formula to solve for RE as follows: R E = D 1 P 0 + g Because R E is the return that the shareholders require on the stock, it can be interpreted as the firm’s cost of equity capital. - Advantages and Disadvantages of the Dividend Growth Approach The primary advantage of the dividend growth model approach is its simplicity. It is both easy to understand and easy to use. There are a number of associated practical problems and disadvantages. Firstly, we can only calculate cost of equity based on SML approach for companies that pay dividends. This means that the approach is useless in many cases. Furthermore, even for companies that do pay dividends, the key underlying assumption is that the dividend grows at a constant rate. More generally, the model is really only applicable to cases in which reasonably steady growth is likely to occur. Secondly, the estimated cost of equity is very sensitive to growth rate. For a given stock price, an upward revision of g by just one percentage point, for example, increases the estimated cost of equity by at least a full percentage point. Because D 1 will probably be revised upwards as well, the increase will actually be somewhat larger than that. Finally, this approach really does not explicitly consider risk. Unlike the SML approach (which we consider next), there is no direct adjustment for the riskiness of the investment. For example, there is no allowance for the degree of certainty or uncertainty surrounding the estimated growth rate for dividends. As a result, it is difficult to say whether or not the estimated return is commensurate with the level of risk. The SML Approach 4 The primary conclusion was that the required or expected return on a risky investment depends on three things: - The risk-free rate, R f - The market risk premium, E(R M ) – R f - The systematic risk of the asset relative to average, which we called its beta coefficient. Using the SML, we can write the expected return on the company’s equity, E(R E ), as: E(R E ) = R f + β E * (E RM – R f ) where E is the estimated beta. To make the SML approach consistent with the dividend growth model, we will drop the Es denoting expectations and henceforth write the required return from the SML, RE, as: R E = R f + β E * (E RM – R f ) - Advantages and Disadvantages of the Approach The SML approach has two primary advantages. First, it explicitly adjusts for risk. Second, it is applicable to companies other than just those with steady dividend growth. Thus, it may be useful in a wider variety of circumstances. However, there are some disadvantages when using the SML approach. Firstly, it is not always easy to estimate both the market risk premium and the beta coefficient. If we can not estimate these estimates, the cost of equity can not be figured out. For example, our estimate of the market risk premium, 9.1 percent, is based on about 75 years of returns on a particular portfolio of stocks. Using different time periods or different stocks could result in very different estimates. In addtion, as we use the information in the past to tell about the future when using SML approach, the results are not always significant as past information can not always guide future direction in this changing world. In the best of all worlds, both approaches (the dividend growth model and the SML) are applicable and the two result in similar answers. If this happens, we might have some confidence in our estimates. We might also wish to compare the results to those for other, similar, companies as a reality check. 1.1.1.2. Cost of debt The cost of debt is the return that the firm’s creditors demand on new borrowing. In principle, we could determine the beta for the firm’s debt and then use the SML to estimate the required return on debt just as we estimated the required return on equity. This isn’t really necessary, however. Unlike a firm’s cost of equity, its cost of debt can normally be observed either directly or indirectly, because the cost of debt is simply the interest rate the firm must pay on new borrowing, and we can observe interest rates in the financial markets. For example, if the firm already has bonds outstanding, then the yield to maturity on those bonds is the market-required rate on the firm’s debt. Alternatively, if we know that the firm’s bonds are rated, say, AA, then we can simply find out what the interest rate on newly issued AA-rated bonds is. Either way, there is no need to estimate a beta for the debt because we can directly observe the rate we want to know. 5 There is one thing to be careful about, though. The coupon rate on the firm’s outstanding debt is irrelevant here. That rate just tells us roughly what the firm’s cost of debt was back when the bonds were issued, not what the cost of debt is today.5 This is why we have to look at the yield on the debt in today’s marketplace. For the sake of consistency with our other notation, we will use the symbol RD for the cost of debt. 1.1.1.3. Cost of preferred stock Determining the cost of preferred stock is quite straightforward. As we know, preferred stock has a fixed dividend paid every period forever, so a share of preferred stock is essentially a perpetuity. The cost of preferred stock, R P , is thus: R P = D/P 0 where D is the fixed dividend and P 0 is the current price per share of the preferred stock. Notice that the cost of preferred stock is simply equal to the dividend yield on the preferred stock. Alternatively, because preferred stocks are rated in much the same way as bonds, the cost of preferred stock can be estimated by observing the required returns on other, similarly rated shares of preferred stock. 1.1.1.4 Weighted Average Cost of Capital (WACC) Weighted Average Cost of Capital (WACC) is the weighted average of cost of each component in a company’s capitap structure. These components can be debt, equity, preferred stock, options, warrants, etc. However, we usually limit the components to debt, equity and preferred stock to come up with the formula of WACC below: WACC= E V ∗R E + P V ∗R V + D V ∗ ( 1−T c ) ∗R D Where E/V, P/V, D/V are the weights of equity, preferred stock and debt in the firm’s value, R E , R D and R P are return on equity, return on debt and return on preferred stock respectively, T c is corporate tax. WACC is used to indicate the minimum return that a company must earn on an existing asset base to satisfy its creditors, owners, and other providers of capital, or they will invest elsewhere. 1.1.2. Capital structure and capital structure policy 1.1.2.1. Leverage, Capital Structure and Optimal Capital Structure a. Capital Structure A firm’s capital structure (or financial structure) is the specific mixture of debt and equity the firm uses to finance its operations. 3 3 Ross et al., 2003: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition, McGraw Hill, P.6 6 As for capital structure question, the financial manager has two concerns in this area. First, how much should the firm borrow? That is, what mixture of debt and equity is best? The mixture chosen will affect both the risk and the value of the firm. A primary reason for studying the WACC is that the value of the firm is maximized when the WACC is minimized. To see this, recall that the WACC is the discount rate that is appropriate for the firm’s overall cash flows. Because values and discount rates move in opposite directions, minimizing the WACC will maximize the value of the firm’s cash flows. Thus, we will want to choose the firm’s capital structure so that the WACC is minimized. For this reason, we will say that one capital structure is better than another if it results in a lower weighted average cost of capital. Further, we say that a particular debt equity ratio represents the optimal capital structure if it results in the lowest possible WACC. This optimal capital structure is sometimes called the firm’s target capital structure as well. However, it is not an easy task to find out a firm’s optimal structure. Therefore, different theories have been developed to solve this problem. Modigliani and Miller theory, the Static trade theory, the Pecking order theory and the Agency costs theory are among the most popular theories. These theories will be discussed in the second section of this chapter. b. Leverage In general, leverage is the result of the use of fixed-cost assets or finds to magnify the returns to the company’s shareholders. Leverage is categorized into operating leverage and financial leverage. However, in ths thesis, the author only focuses on financial leverage, which refers to the extent to which a firm relies on debt. The more debt financing a firm uses in its capital structure, the more financial leverage it employs. When deciding on how much debt to use, the financial manager must consider carefully as leverage magnifies both returns and risks the company has to face. The type of risk here is financial risk, which is the additional risk concentrated on common stockholders as a result of financial leverage. It is not business risk, which is the risk of companies’ fixed assets without any debt. The figure below illustrates how leverage magnifies both risk and return for a company. Figure1. How leverage magnies both risk and return of a firm Company U: No debt; Equity = 10.000; Tax rate = 40% Recession Expected Expansion EBIT 2.000 3.000 4.000 Interest 0 0 0 Net Income 2.000 3.000 4.000 ROE 6% 9% 12% EPS Risk measure: σ ROE = 2.12% Risk measure: CV ROE = 0.24 7 Company L: Debt = 10.000; Equity = 10.000; Tax rate = 40% Recession Expected Expansion EBIT 2.000 3.000 4.000 Interest 1.200 1.200 1.200 Net Income 800 1.800 2.800 ROE 4.8% 10.8% 16.8% EPS Risk measure: σ ROE = 4.24% Risk measure: CV ROE = 0.39 Source: http://www.umflint.edu/~mjperry/361-CH13Concise.ppt Leverage and capital structure are connected in the way that they contribute to how a firm chooses to finance its projects in order to maximize shareholders’ value. The proper use of debt in a company’s capital structure in the right time can increase returns to shareholders significantly while the abuse of debt in bad time can damage shareholders’ value to an incredible extent. Throughout this research, leverage is used to represent capital structure and the effect of leverage on firm performance is the same as the effect of capital structure on firm performance. 1.1.3. Measurement of Firm Performance The concept of performance is a controversial issue in finance largely due to its multidimensional meanings. Research on firm performance emanates from organization theory and strategic management (Murphy et al., 1996). Performance measures are either financial or organizational. Financial performance such as profit maximization, maximizing profit on assets, and maximizing shareholders' benefits are at the core of the firm effectiveness (Chakravarthy, 1986). Operational performance measures, such as growth in sales and growth in market share, provide a broad definition of performance as they focus on the factors that ultimately lead to financial performance (Hoffer and Sandberg, 1987). The usefulness of a measure of performance may be affected by the objective of a firm that could affect its choice of performance measure and the development of the stock and capital market. For example, if the stock market is not highly developed and active then the market performance measures will not provide a good result. The most commonly used performance measure proxies are return on assets (ROA) and return on equity (ROE) or return on investment (ROI). These accounting measures representing the financial ratios from balance sheet and income statements have been used by many researchers (e.g., Demsetz and Lehn, 1985; Gorton and Rosen, 1995; Mehran, 1995; and Ang, Cole and Lin, 2000). However, there are other measures of performance called market performance measures, such as price per share to the earnings per share (PE) (Abdel Shahid, 2003), market value of equity to book 8 value of equity (MBVR), and Tobin’s Q. Tobin’s Q mixes market value with accounting value and is used to measure the firm's value in many studies (e.g., Morck, Shleifer, and Vishny, 1988; McConnel and Serveas, 1990; and Zhou, 2001). The performance measure ROA is widely regarded as the most useful measure to test firm performance (Reese and Cool, 1978; Long and Ravenscraft, 1984; Abdel Shahid, 2003, among others). The stock market efficiency and other economic and political factors could affect a firm performance and its reliability (See Abdel Shahid, 2003). Firm performance may also affect the choice of capital structure. As Berger and Bonaccorsi di Patti (2006) point out, regressions of firm performance on leverage may confound the effects of capital structure on performance with the reverse relationship from performance on capital structure. This reverse causality effect is in essence a feature of theories considering how agency costs (Jensen and Meckling, 1976; Myers, 1977; and Harris and Raviv, 1990); corporate control issues (Harris and Raviv, 1988); and in particular, asymmetric information (Myers and Majluf, 1984; Myers, 1984) and taxation (DeAngelo and Masulis, 1980; and Bradley et al., 1984) are likely to affect the value of the firm. 1.2. Theories of capital structure The topic of capital structure, especially optimal capital structure is of interest of many researchers throughout the years. They have been trying to find out which is the best mixture of debt and equity for a firm by finding the answers to these questions: - When should firms finance? - Which sources of finance among debt, equity, preferred stock, etc should firm choose to finance their projects? - If debt is employed, how much short-term debt and long-term debt should be used? - If shares are issued, which groups of stock should be issued? Below is the summary of popular capital structure theories Table 1. Summary of popular capital structure theories No. Theory Effect (1) Effect (2) Results 1 Modiglia ni and Miller Approach (Non-debt tax shield) L↑ K↑ R↑ V↓ Debt tax shield L↑ K↓ V↑ 9 2 Static Trade Off Theory L↑ K↓ Financial Distress↑ Trade-off →V↑ 3 Pecking Order Theory First internal sources and then external sources↑ Endeavor to invest on positive net present value projects↑ Fist, benefit for present shareholders and then an opportunity for new investors↑ 4 Agency Cost Theory Conflict of interest between management ,shareholders and creditors↑ N/A V↓ Conflict of interest between management, shareholders and creditors↓ N/A V↑ 5 Signaling Theory Financial decisions are signals for investors↑ N/A Asymmetric of information can be solved by signaling theory↑ 6 Market Timing Theory Overvalue of shares↑ Issue new shares V↑ Undervalue of shares↑ Buyback their shares V↑ L= Leverage, K= Cost of capital, V= Value, R= Expected return, ↑= increase and ↓= decrease Source: Hamed Ahmadinia, Javad Afrasiabishani, Elham Hesami, 2012. A Comprehensive Review on Capital Structure Theories. Romanian Economic Journal. P.7,8 Due to the limited scope of the thesis, the writer will only discuss the first four theories, which are Modigliani and Miller Approach, Static trade-off theory, Pecking order theory and Agency cost theory. 1.2.1. Modigliani and Miller (M&M) a. The no-tax case Proposition I: The value of the firm levered (V L ) is equal to the value of the firm unlevered (V U ): V L =V U 10