The irrelevant capital structure of Modigliani and Miller (1958) suggests that in a perfect capital market firm value is independent of firm capital structure, and thus an optimal capital structure does not exist. However, the assumption of perfect capital markets is unrealistic: taxes, friction, agency costs, and differences in information all exist in reality. Choice of capital structure is important on the objective of firm-value maximization.
Theories of capital structure suggest that some factors might be correlated with leverage. The prevailing views, for example Harris and Raviv (1991), contend that financial variables, for example firm size, growth opportunities, tangibility, and profitability, have influences on the capital structure. Rajan and Zingales (1995) and Wald (1999) find that the above characteristics, which are believed to correlate with leverage in U.S., also influence firm leverage in industrialized countries. Moreover, evidence from Rajan and Zingales (1995) shows that capital structure is fairly similar across these countries. Thus these findings indicate that firm factors identified as correlated in the cross-section with firm leverage in U.S., are similarly correlated in other countries, but it appears that the country factors do not explain the variations in capital structure. However, empirical evidences are completely based on firms in well-developed (G-7) countries, and little is known regarding the capital structure in emerging markets. The legal and institutional environments in emerging markets are believed to differ markedly from those in developed markets.
Booth et al. (2001), as a pioneering work on the capital structures of emerging markets, concluded that, to forecast firm leverage, it is more important to know firm country than firm characteristics. The analytical results obtained by Booth et al.revealed that cross-country differences in taxes, institutional environments, and even investor protection might profoundly affect firm leverage. To the best of our knowledge, however, there is no study to examine their relation. The main motivation for this study is to highlight the role of firm characteristics and institutional differences in determining capital structure through examining international data.
This study examines the capital structure of firms in 45 countries from Asia, Europe, North America, South America, Africa, and Australasia. The objective is to establish whether factors identified by previous works that appear to influence firm leverage in G-7 countries can also be applied to other developed and developing countries, and whether the difference in the aggregate capital structure of countries, if such a variation exists across these countries, is attributable to differences in their legal and institutional environments. This study employs several country factors, including the importance of capital markets and banking sectors, national development, inflation, taxes, and most important, shareholder rights and creditor rights, to examine the cross sectional relationship between capital structure and institutions.
This study first analyzes the determinants of capital structure for firms in each country. The relation between firm characteristics and leverage found in the present sample is familiar from previous works. Apparently, firm characteristics correlated in the cross-section with capital structure in developed markets are similarly correlated in our sample countries as well. Although these countries have common determinants of capital structure, these firm characteristics have difficulty explaining cross-country variation in aggregate capital structure. This study then classifies the firms by the legal origin, major language, major religion, and GDP per capital of their country, respectively. Systematic differences are found for these classifications.
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Investor Protection and Capital Structure: International Evidence
