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Financing decisions and the investment opportunity set: Some evidence from Japan
ELSEVIER
Pacific-Basin
Finance Journal
2 (1994) 227-242
Financing decisions and the investment opportunity set: Some evidence from Hoje Jo *a, John M. Pinkerton b and Atulya Sarin a ’ Leavey
Schoolof Business,
Santa Clara
Unirersity, Santa Clara, CA 950.53, USA b R.B. Pantplin College of Business, Virginia Po.‘ytechnic lnstitute and State Utukersity, Blacksburg, VA 24061, USA
Abstract
This paper examines the empirical reiation between corporate financing and investment opportunities in Japan. In contrast to the findings in U.S. firms, we find that for a sample of 1,044 Japanese firms with data available on Pa&EC-Basin Capital Markets (PACAP) database over the period 1986-1990, there is a positive relationship between book debt-equity ratios and our measure of investment opportunities. These results are consistent with the joint hypotheses that the negative relationship found in the U.S. is because of agency conflicts and these conflicts are mitigated in Japanese firms because of their institutional arrangements. We also document that contrary to the common belief of potentially unique behavior of keiretsu firms because of their stronger ties to banks and other financial institutions, there are no significant differences between keiretsu firms and independent firms leverage, growth opportunities, firm size, and the relationship between investment opportunities and financial decisions. Key words: Financing decisions; Investment
opportunity
set; Agency model; Keiretsu
JEL classification: G32 _
__~~_.~___
__-
___.
1. Introduction
It is well-documented
that
there
is a negative
association
between
debt
* Corresponding author. Tel. (408) 554-4385. We are extremely thankful to David Denis, Ghon Rhee, and Sheridan Titman for providing insightful comments and suggestions. We would like to thank Lynch, Jones and Ryan Co. for providing the analyst forecast data. This work has been partially supported by research grants from Leavey School of Business. This paper received the Chicago Board Options Exchange Competitive Research Award. 0927-538X/94/$07.00 I(‘I 1994 tllsevier Science SSI)f 0927-538X(93)0001 6-Z
.v. AH rights reserved
228
H. Jo et a!. / Pacific-Basin Finance Journal 2 ( 1994) 227-242
levels and investment opportunities in U.S. firms! This relationship is consistent with at least two alternative theoretical frameworks. One argument is that agency conflicts cause firms with an abundance of positive NPV investment opportunities to issue equity rather than debt to finance their new investment. For example, Myers (1977) points out that the stockholders of firms with a high chance of bankruptcy are unlikely to provide new capital, even to finance positive NPV projects. The stockholders’ reluctance to invest more in the financially distressed firm stems from the reality that, while they bear the entire cost of the investment, the existing debt-holders capture most of the investment’s return. Thus, when facing financial distress, a company’s existing large debt level provides the firm’s stockholders an incentive to reject positive NPV projects. Myers concludes that firms not facing financial distress but expecting positive NPV investment opportunities will prefer to maintain low levels of debt to finance their current positive NPV projects with equity. Also, Jensen (1986) and Stulz (1990) argue that managers have an incentive to invest all available funds even if it requires investing in some negative NW projects. Debt service payments reduce the amount of funds managers have at their discretion for profitable investments. Thus, the managers of firms expecting to have positive NPV investment opportunities prefer to finance those opportunities with equity. Only when positive NPV opportunities diminish and free cash flow increases will managers use debt. The alternative explanation is based on the tax code provisions originally pointed out by DeAngelo and Xasulis (1980) and Dotan and Ravid (1985). They argue that positive NPV investments create non-debt tax shields and since debt related and investment related tax shields are perfect substitutes, the incentive for debt financing disappears as positive NPV investment opportunities increase. Thus growth firms should, at the margin, be financed by less debt. MacKie-Mason ( 1990) and Dhaliwal et al. (1992) show that taxes play an important role in the firm’s capital structure decision. Specifically, they show that the effect is more pronounced to firms which have a substantial probability of losing the deductibility of tax shields. Using a tax law change, Trezevant ( 1992) also finds that an increase in non-debt tax shields leads to a decrease in leverage and interprets this evidence as an empirical support for the substitution effect and the tax exhaustion hypothesis. The findings of Givoly et al. (1992) further indicate that there exists a substitution effect between debt and nondebt tax shields, and that both corporate and personal ’ The investment opportunity set is typically characterized as the proportion of firm value represented by growth options and is measured by the market-to-book value of equity. Smith and Watts (1992). Jung et al. (1992). Gaver and Gaver (1993), and Pinkerton and Sarin (1993) found a negative relation between debt ratios and the market-to-book value of equity.
H. Jo et d.
1
Puc$c-Busin
Finance Journul 2 ( 1994) 227-242
229
tax rates affect leverage decisions. They also find a positive association between changes in leverage and changes in corporate taxes, thus supporting the tax-based theories of capital structure. In this paper, we attempt to determine which of these explanations, agency or taxes, is the dominant reason for this observed relationship between investment opportunities and financial policy. We do so by examining the same relationship in the Japanese market, where the tax code provision is similar to the U.S., but the agency conflicts are mitigated to a larger extent. Japanese financial institutions are allowed to take large positions in the debt and equity of the same firm. Most U.S. financial institutions are not. This difference affects the degree to which these large investors can reduce the inherent principal-agent conflict between the shareholders and debtholders of the firms. Also, large equity stakes by Japanese financial institutions and their active monitoring of corporate policy reduces the agency conflict between owners and managers by controlling managers’ consumption of perquisites and by reducing their scope to pursue goals other than profit maximization. Prowse (1990) finds that Japanese financial institutions take large equity positions in firms more susceptible to the agency problem. Also debt ratios of U.S. firms are negatively related to the firm’s potential to engage in risky suboptimal investments, whereas Japanese debt ratios show no such relation. He concludes that this evidence is consistent with the notion that the agency problem is mitigated to a greater degree in Japan than in the U.S. Gerlach (1992) also indicates that the seemingly clear categories of principal and agent become blurred due to the reciprocal relationships as the managers of one firm become the owners of another, and in turn are held by managers of that firm. If indeed agency reasons cause the negative relationship between investment opportunities and leverage found in the U.S. and the institutional arrangements in Japan mitigate the agency problems, we expect Japanese firms to not show a negative relation between leverage and measures of investment opportunities. Alternatively, if tax reasons are the dominant cause for this association, we expect the relationship to persist in Japan. Thus, we examine the relationship between investment opportunities and leverage for a sample of Japanese firms to identify the major determinant for this relationship. We find that for our sample of 1044 Japanese firms over the period 19861990, there is a positive relation between the book debt-equity ratio and our measure of investment opportunities. We further examine the relationship after partitioning our sample as keiretsu firms or non-keiretsu firms. Recent studies indicate that differences between keiretsu and independent firms are large enough to yield observable differences in behavior. However, we find that our results are invariant to this classification. We interpret our evidence
as support for the agency models of capital structure of Myers (1977), Jensen (1986) and Stulz ( 1990). The remainder of the paper is organized as follows. In section 2 we discuss the relationship between financing policy and investment opportunities. Section 3 documents taxes, information asymmetry and investment opportunities. The paper ends with a conclusion in Section 4.
2. Relationship between financing policy and investment opportunities 2.1. San@
6kscrip tion
The sample data consist of all Japanese companies listed on the 1992 tape compiled by the Pacific-Basin Capital Markets (PACAP) Research Center at the University of Rhode Island that have complete annual observations between March 1986 and March 1990. To remain in the sample, each firm must have a March year end2. To investigate the relation between financing policy and the invest.ment opportunity set for Japanese firms, we delete financial institutions and public utilities from the sample to avoid the confounding effects of regulation on corporate financing decisions. This leaves us with our sample of 1044 firms. We measure the following variab!es for financing policy and investment opportunities over the period 19861990. Financing decisions are measured by using the debt-equity ratio. We compute four versions of this ratio. The first two versions are total debtequity ratios used by Gaver and Gaver (1993): book total debt-equity and market total debt-equity. The book total debt-equity ratio is total debt divided by total common equity plus preferred stock. The market total debtequity is total debt divided by the market value of common equity plus the book value of preferred stock. The last two versions are long-term debtequity ratios suggested by Titman and Wessels (1988). They argued that agency costs are likely to be higher for firms in growing industries, which have more flexibility in their choice of future investments and that expected future growth should thus be negatively related to long-term debt levels. The historical (book) long-term debt-equity ratio is long-term debt divided by book value of common equity plus book value of preferred stock. The market long-term debt-equity ratio is long-term debt divided by market value of common equity plus book value of preferred stock. Since the market debt-equity ratios are sensitive to share price while the book debt--equity ratios are not, we view the book debt-equity ratios as our primary measures
’ WC require the firms to have the same fiscal year end so that our estimations
of mark:
value
of financing. However, to keep comparability Jvith Smith and Watts (1992) and Gaver and Gaver (1993), we also examine the market debt-equity ratios. The next step is to estimate growth opportunities. We use the market-tobook value of common equity ratio (MKTBOOK) following Lewellen et al. (1987) and Gaver and Gaver (1993) as our primary measure of growth opportunities”. Gaver and Gaver (1993) use MKTBOOK to classify firms as growth and non-growth firms. However, we use the continuous variable of growth opportunities rather than dichotomized growth and non-growth firms because a continuous spectrum can provide broader information on growth opportunities and can avoid the arbitrary classification of growth and nongrowth firms. The market-to-book equity ratio is calculated as: MKTBOOK =(Closing price per share x Number of shares outstanding)/total common equity with all variables measured at the fiscal year end. All firms with negative book value of equity are deleted from the sample. Although the nature of the relation between the investment opportunity set and firm size is not well understood, Smith and Watts ( 1992) indicated that the greater diversification of larger firms enables them to have larger debt capacity and therefore hig..kl her debt+quity ratios than smaller firms to the extent that costs of financial distress limit leverage. Because of this reason, Smith and Watts ( 1992) Jung et al. ( 1992), Gaver and Gaver ( 1993) and Pinkerton and Sarin ( 1993) use firm size as a control variable. We also include firm size (measured as the natural log of total assets) as an explanatory variable in our analysis.
2.2. Result
Table 1 presents means, standard deviations and Pearson correlation coefficients for our variables of interest. For 1044 Japanese firms for which this information is collected, Table 1 reveals that the average book total debt-equity is 3.94 (equivalent to debt ratio of 79.76:,<) and market total debt-equity ratio is 0.87 (equivalent to debt ratio of 46.527,~). As expected, all four versions of debt-equity ratios are highly correlated with each other and with firm size. These high correlations with the firm size variable could result in a spurious relationship between debt-equity ratios and investment oppor-
3 Although there is no single, universally accepted, empirical proxy for the investment opportunity set, the market-to-book value of shareholders’ equity ratio and the market value of the firm to the book value of assets ratio are widely used as primary measured of the growth opportunity. Lang and Litzenberger (1989) used Tobin’s Q to proxy for a firm’s expected investment opportunities in future periods. Pilotte (1992) used dividend policy, growth rates of the market value of equity, sales, net operating income, and total assets as proxies for growth opportunities. Without doubt, any classification schene is likely to contain error.
Table 1 Descriptive statistics and Pearson correlation coefficients. Summary statistics including means, standard deviations, and Pearson correlation coefficients for the sample of 1044 Japanese Industrial firms. P-values are in parentheses _____~__~__.__--_
_ _.. ~- _--.-
BDE
MDE
BLDE
MLDE
MKTBOOK
ASSET x 10”
Mean
3.94
0.87
0.56
0.09
4.89
1.85
Std. Dev.
5.91
0.97
2.10
0.20
4.34
5.42
1.00
0.63 to.001
0.78 (0.00)
0.58 (0.00)
0.56 (0.00)
0.11 ww
1.00
0.29 (0.00)
0.74 (0.00)
-0.01 (0.74)
0.24 (0.00)
1.00
0.57 (0.00)
0.52 (0.00)
0.07 (0.02)
1.00
0.15 (0.00)
0.28 (0.00)
1.00
0.00 (0.97)
Correlations Book Debt-equity” (BDE) Market Debt-equityb WDE) Book Long-term Debt-equity Market Long-term Debt-quity
(BLDE)’
( MLDE)d
MKTBOOK’ ASSETxlO! “
1.00
’ Book debt+quity = total debt divided by the book value of common equity plus the book value of preferred stock. h Market debt-equity = total debt divided by the market value of common equity plus the book value of preferred stock. ’ Long-term debt divided by the book value of common equity plus the book value of preferred stock. d Long-term debt divided by the market value of common equity plus the book value of preferred stock. ’ MKTBOOK = market-to-book value of common equity. f In Japanese yens.
(unities. Thus, as argued above, in order to prevent the potentially spurious relationships, we include the firm size variable in our regression. Capita! st r uctuse changes are lumpy and relatively infrequent causing the debt ratio at a particular point in time to be higher or lower than the optimal levels. To account for any measurement error which may arise because of that, we use the average of each variable including debt-equitv ratios over the five years of 19861990. Previous researchers such as Smith and Watts (1992), and Gaver and Gaver (1993) have typically examined only debt/asset or debt-equity ratios, which at a particular point in time reflect ulativc result of years of separate decisions. Such tests based on a
Table 2 Parameter estimate of cross-sectional regressions. Estimates of cross-sectional regressions relating the debt-equity ratio to investment opportunities and firm size for a sample of 1044 Japanese firms with data available on PACAP database over the period 1986-1990. The dependent variable in: model { 1) is historical (book) total debt-equity ratio (book value of total debt divided by book value of common equity plus book value of preferred stock), model (2) is market total debt-equity ratio (book value of total detl divided by market value of common equity plus book value of preferred stock), model (3) is historical (book) long-term debt-equity ratio (long-term debt divided by book value of common equity plus book value of preferred stock), model (4) is market long-term debtequity ratio (long-term debt divided by market value of common equity plus book value of preferred stock). T-statistics are in parentheses
Independent Intercept MKTBOOK” LASSETSb Adjusted R’ F-value (Prob > F)
variables
Model ._.____~ (1)
_.~____-~ (2) ------ 13.79 - 3.94 ( - 4.87**) (-7.21**) 0.78 - 0.02 (22.51**) (-0.31) 0.56 0.19 (4.95**) (8.85**) 0.33 0.07 258.88 39.19 (o.oo**)
(o.oo**)
__-__ (3)
.-___
- 3.36 (-3.21**) 0.25 (19.95**) 0.11 (2.57*) 0.28 70.53 (o.oo**)
(4) --.. ~_ _ -_ - 0.95 ( - 8.35**) 0.01 (5.87**) 0.04 (8.89”“) 0.09 53.24 (o.oo**)
a MKTBOOK
= market-to-book value of common tquity. b LASSETS = natural log of total assets. *Significantly different from zero at the 5 percent level. **Significantly different from zero at the 1 percent level.
cumulative financing measure are likely to have lower statistical power for identifying a potentially time-varying optimal leverage ratio. Table 2 presents results of cross-sectional regressions relating leverage, variables to our measure of investment opportunities (MKTBOOK) and firm size (LASSETS) for a total sample of 1044 Japanese firms with data available on PACAP database over the 1986-1990 period. The dependent variable in: model ( 1) is historical (book) total debt-equity ratio (book value of total debt divided by book value of common equity plus book value of preferred stock), model (2) is market total debt-equity ratio (book value of total debt divided by market value of common equity plus book value of preferred stock), model (3) is historical (book) long-term debt-equity ratio (long-term debt divided by book value of common equity plus book value of preferred stock), model (4) is market long-term debt-equity ratio (long-term debt divided by market value of common equity plus book value of preferred stock). The results reported in Table 2 show that the book total debt-equity ratio and book long-term debt ratio are significantly positively related to investfirms of a gs a ment opportunities. This is contrary to the fi
negative relationship. The relationship between market long-term debt ratio and investment opportunities is significantly positive which is also contrary to what has been argued by Xtman and Wessels (1988) for U.S. firms. However, the market debt-equity ratio is sensitive to share price. Specifically, firms with high (low) share price will have a low (high) market debt--equity ratio and a high (low) market to book ratio. This would lead to a spurious relationship between the financing policy and our measure of investment opportunities. This should bias the coefficient to be negative, yet it is still positive in model (4). Therefore, 2s stated earlier, we view the book debtequity ratio as our primary measure of financing policy. We also make two other observations from this Table. First, when book ratios are used as the dependent variable, the estimated coefficients on both explanatory variables are larger (in absolute value) and the regressions have a higher adjusted I?‘. This implies, that the book ratios are better explained by our theories of capital structure. Secondly, all four versions of debt-equity ratios are positively related to the firm size variable. Perhaps, as Smith and Watts ( 1992) indicated, this is because the greater diversification of larger firms enables them to have higher leverage than smaller firms to the extent that costs of financial distress limit leverage. This positive correlation between debt-equity ratio and firm size in Japanese tirms is consistent with earlier U.S. evidence reported by Smith and Watts (1992). Jung et al. (1992). Gaver and Gaver ( 1993), and Pinkerton and Sarin ( 1993).
2.3. KtGrc*tstr and independent firms The Japanese capital markets and corporations possess institutional arrangements that differ from the U.S. One of the important institutional features of Japanese firms is that many Japanese firms belong to keirefsu - for example. Mitsubishi, Mitsui, Sumitomo, Fuji, I&i-ichi Kangyo, groups Sanwa, and Tokai among others - in which some groups have a large commercial bank at the center and bank-affiliated firms receive substantial debt and equity financing from the bank. The terminology of keiretstr is typically used to refer to two different sets of relationships: vertical groupings of upstream supplier firms and downstream distributors affiliated with a large manufacturing or commercial enterprise and diversified groups called ‘horizontal’ kviretsu following Japanese terminology of _&XI keirvtsu by some observers, comprising a commercial bank and other financial institutions. one or more trading companies, and a range of large manufacturing firms. Even nob-kuirt~su groups may contain many of the similar institutional features as those more clearly defined as kriwtszr. Firms such as Toyota or Hitachi carry out most of their usiness with vertically or horizontally linked suppliers and dis-
tributors. For example. Toyota sits on the presidents’ council of the Mitsui grout. while Hitachi sits on the presidents’ councils of the Fuji, Sanwa, and Dai-Ichi Kangyo Bank groups. Recent studies indicate that differences between keiru~r and independent firms are large enough to yield observable havior. For ifferences in example, Hoshi et al. (1990a. 1991) report that keirets~ firms’ investments are less liquidity-constrained than are independent firms because of their closer ties to a major creditor and the lower cost of debt financing. Prowse ( 1992) also suggests that kuirerstr firms differ from independent firms that have more arms-length type relationships with other firms and financiers. These dif’ferences in institutional arrangements may influence the Japanese firms’ financing decisions and the behavior of shareholders as monitors. Gerlach ( 1992) also notes that close relationships among banks, shareholders, and business partners associated with keiretsu groups are seen as a potential source of Japanese competitive advantage, particularly in channeling the activities cf corporate man agers in the direction of long-term growth and profitability. Thus, we expect some potential differential behavior in financing policy, growth opportunities, or the investment opportunity-financing decision relations between keiretsu firms and independent firms. To examine this potential difference between keiretsu firms and independent firms, we attempt to classify Japanese firms into keiretsu groups and non-keirersu groups. Kester ( 1991) defines the Japanese keiretsu as a group of companies federated around a major bank, trading company, or large industrial firm. However, determining which firms are afftliated and which are independent is somewhat difficult. Following Hoshi et al. ( 1990a,b, 199 1) and Prowse ( 1990. 1993, we chose Nakatani’s ( 1984) classification scheme because it focuses on the strength of a firm’s relationship to the financial institutions in the group: the propensity to borrow from group banks and insurance companies and the percentage of shares held by other group firms. Using Nakatani’s ( 1984) classification for our sample, we are able to classify 171 firms as keiretsu and 48 firms as non-keiretsu. We provide the results of a Wilcoxon signed-rank test between 171 keiretsu firms and 48 non-keiretsu firms in terms of financial policy, growth opportunities, and firm size in Table 3. The comparison between keirutsu firms and non-keiretsu firms during the 1986-1990 period reveals that the book debtequity. market debt-equity, book long-term debt-equity, market long-term debt-equity, market-to-book ratio (MKTBOOK), and firm size measured as total assets (ASSET) are not significantly different between keiretsu and independent firms based on the Wilcoxon signed-rank test, although the absolute values for the medians and the means of book debtequity, market debt-equity, book long-term debt-equity, market long-term debt-equity, and MKTBOOK in keiretsu firms are larger than those of nonkeirefsu firms. In contrast with recent studies that indicate potentially large
H. Jo et al. / Puc@Basin
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( 1994) 227-242
Table 3 Wilcoxon signed-rank test between keiretsu firms and independent firms. A comparison between 171 kerretsu firms ;;I:’ 4.2 independent firms in terms of linancial policy measured by debt-equity ratios, growth opportunities measured by market-to-book value of equity (MKTBOOK), and firm size measured by total assets (ASSET) with data available on the PACAP database over the period 1986-1990 Keiretsu groups (N= 171)
Non-keiretsu (N=48)
groups
Wilcoxon prob.”
Mean
Median
Mean
Median
Book Debt-equityb
3.41
2.35
2.69
1.96
0.13
Market Debt-equity’
0.77
0.61
0.64
0.51
0.25
Book Long-term Debt-equityd
0.43
0.09
0.27
0.05
0.09
Market Long-term Debt-quit!’
0.09
0.03
0.06
0.02
0.10
MKTBOOK’
4.79
3.95
4.29
3.49
0.21
ASSET x 10’ ‘g
2.72
1.08
2.52
0.87
0.65
“The probability that the absolute value of the Wilcoxon signed rank z-statistic for keiretsu groups is different form the absolute value of the observed -?-statistic of non-keiretsu groups. b Book debt-equity= total debt divided by the book value of common equity plus the book value of preferred stock. Market debt-equity= total debt divided by the market value of common equity plus the book value of preferred stock. d Long-term debt divided by the book value of common equity plus the book value of preferred stock. ‘Long-term debt divided by the market value of common equity plus the book value of preferred stock. ’ MKTBOOK = market-to-book value of common equity. 8 In Japanese yens.
differences between keiretsu and independent firms in terms of observable differences in behavior, we find that these firms are similar”. In order to see whether there is any difference between keiretsu firms and non-keiretsu firms for the relationship between investment opportunities and leverage, we display the results from the OLS estimation of further crosssectional regressions, in which we add a dummy variable (one for kvirvtsu firms and zero for non-keiretsu firms), and an interaction term between the dummy variable and MKTBOOK in Table 4. oshr et al.
( 199l)
and Prowse
( 1992).
Table 4 Parameter estimate of further cross-sectional regressions. Estimates of further cross-sectional regressions relating the debt-equity ratio to investment opportunities, firm size, dummy variable (one for keiretsu firms and zero for non-keiretsu firms), and interaction variable for a sample of 171 keiretsu firms and 48 non-keiretsu firms with data available on PACAP database over the period 19861990. The dependent variable in: model (1) is historical (book) total debt-equity ratio (book value of total debt divided by book value of common equity plus book value of preferred stock), model (2) is market total debt-equity ratio (book value of total debt divided by market value of common equity plus book value of preferred stock), model (3) is historical (book) long-term debt-equity ratio (long-term debt divided by book value of common equity plus book value of preferred stock), model (4) is market long-term debt-equity ratio (long-term debt divided by market value of common equity plus book value of preferred stock). T-statistics are in parentheses Model Independent Intercept MKTBOOK” LASSETSb
variables
(1) 11 d.29 ( - 2.14’) 0.72 (4.31**) 0.39 (2.13*)
DUMMY
-092 (-1.00)
DUMMY x MKTBOOK
- 0.26 ( - 1.47)
Adjusted R2 F-value ( Pro b > F)
(2)
(3)
-2.51 ( - 2.43’)
- 3.55 ( - 2.82*)
- 0.89 ( - 3.19**)
- 0.04 (1.07)
0.09 f 2.05*)
0.01 ( 1.43)
0.14 (2.81**)
0.04 (3.29**)
0.12 (2.99**) 0.22 ( 1.08) - 0.02 ( - 0.60)
-0.25 (-0.01) 0.08 ( 1.59)
0.49
0.03
0.27
52.62
2.78 (0.03*)
21.01
(o.oo*)
(4)
(o.oo**)
0.05 (0.99) i
-0.01 - 0.56) 0.05 3.77 (o.ol**)
a MKTBOOK = market-to-book value of common equity. b LASSETS = natural log of total assets. * Significan tl y different from zero at the 5 percent level. **Significantly different from zero at the 1 percent level.
The outcomes reported in Table 4 confirm the positive association of book debtequity ratios and investment opportunities, positive correlation between debt-equity ratios and firm size variable, and higher adjusted R2 under book debt-equity regressions. However, when market ratios are used as dependent variables, the estimated coefficients become insignificant. In addition, more importantly, we found that the estimated coefficients of dummy variables and interaction terms under all four regressions are insignificant. This implies that the relationship between investment opportunities and financing choices of Japanese firms are similar for both kriwtsu firms an
3. Taxes, information asymmetry, and investment opportunities Our previous results are consrstent with the joint hypotheses that the negative relationship found in the U.S. is because of agency conflicts and these conflicts are mitigated in Japanese firms because of their institutional arrangements. However, the same results could be because of other differences in the Japanese market. First, the level of information asymmetry may be higher in Japan. The pecking order theory of financing associated with the information asymmetry model of Myers and Majiluf (1984) predicts firms will finance new investment, first internally, then with debt (then with convertible bonds), and finally, as a last resort, with equity. If the level of information asymmetry is higher in Japan, growth firms with greater needs for external capital will be more reluctant to issue equity because of greater potential for wealth transfer to new shareholders and will have greater amount of debt in their capital structure to reduce the adverse selection costs. This will lead to a positive relationship between investment opportunities and leverage. In fact, Kester (1986) reports that the Tokyo Stock Exchange seems to exhibit characteristics symptomatic of information asymmetries that might foster a reluctance on the part of firms to raise equity capital publicly. It should not be ignored, however, that such potential information asymmetry is not likely to be severe between firms and their main banks. We believe that as far as an information effect on capital structure is concerned, such close relationships between lenders and borrowers in Japan should reinforce a preference for bank debt. Second, the tax advantage of debt may be higher fz Japan thereby offsetting the agency costs of debt. Indeed, the tax models of Myers (1974) and Hite (1977) predict that the higher expected taxable income associated with positive NPV investment opportunities provides incentive to obtain the tax shields associated with debt financing. Thus, firms needing external capital will prefer debt even though the agency conflicts still persist. Regarding 3apanese corporate taxation, the Japanese Diet approved a tax reform which cut the Japanese corporate tax rate from 42’.‘~to 37.5”/; in December 1988. This left the Japanese tax rate only slightly higher than the current rate of 34”,, in the U.S. Frankel (1991) in his survey, concluded that by now little is left of the Japanese tax advantage and many other studies conclude that taxes are at best of second-order importance in comparing the capital structure between the U.S. and Japan. If either the higher information asymmetry or higher tax advantage of debt was causing our observed relationship, we would expect them to be positively correlated to our measure of growth opportunities. We9 along the line of Opler and Titman ( 1991) use divergence of analysts’ opinions as our proxy of information asymmetry. Data required to measure divergence of analysts’ opinions during the 1987-1990 period is obtained
from the Institutional Brokers Estimate System (I,‘B,;“E/S) provided by I/B/ES incorporated. This database reports detailed surve;’ da!? a,! dnalysts’ forecasts of firms annual earnings. We measured divergence of analysts’ opinions by the mean standard deviation of analysts’ forecasts. In particular,
as our data of information asymmetry available start from fiscal year 1988, we estimate mean standard deviation of analysts’ forecasts (D~~~EA~) for March 1988, 1989, and 1990 estimated in December t , and 1989. The analysis of correlation between investment opportunities and our proxy of information asymmetry is based on 870 firms that have complete data from two data sources (PACAP database and I/B/E/S database) for the 1987-1990 period. Data for tax measure (TAX) is obtained from PACAP database and TAX is estimated as income tax plus reserves for corporate
taxes and business taxes, standardized by the total assets. The correlation among investment opportunities, the level of information asymmetry, and the tax advantage of debt are presented in Table 5. As argued above, if information asymmetry is causing the observed relationship between investment opportunities and leverage, we expect growth to be positively correlated with our proxy of information asymmetry similarly for the tax effect. However, Table 5 shows that investment opportunities are negatively (insignilicantly) related to both information asymmetry and tax advantage of debt for the total sample reported in Panel A (keiretsu firms and non-keiretsu lirms reported in Panels B and C). This evidence indicates that neither the level of information asymmetry nor the tax advantage of debt is causing the positive relationship between the investment opportunities and debt-ratios. This provides additional evidence that the positive relationship between financing decisions and investment opportunities found in Japanese firms is because of mitigated agency problems due to their institutional arrangements.
4. Conclusions This paper has examined the empirical relation between corporate financing and the investment opportunities in Japan. In contrast to the findings in U.S. firms, we find that among Japanese firms there is a positive relationship between book debt-equity ratios and our measure of investment opportunities. These results are consistent with the joint hypotheses that the negative relationship found in the U.S. is because of agency conflicts and these conflicts are mitigated in Japanese firms because of their institutional arrangements. However, our analysis does not provide a formal explanation why the relation of investment opportunity set-financing decisions in Japan is positive. One possible explanation for the positive relationship is that bankruptcy
H. Jo YI til. / Pucijic. Bush Finunce Jorrrnal .? ( 1994) .?.?7-?4.?
240
Table 5 Mean, standard deviations, and Pearson correlation coeficients. This table reports means, standard deviations, and Pearson correlations for tax, growth opportunities (MKTBOOK), and information asymmetry (DEVMEAN) variables. Due to the difference in data availability (Tax and MKTBOOK from PACAP database and DEVMEAN from I/B/E/S tapes), number of each variable is different Explanatory
Panel A: Total sample Mean Std. Dev.
variable
MKTBOOK~
TAXb
5.039 3.929
0.047 0.029
2.707 4.803
1.W
-0.162 (0.0001) 1.000
-0.127 (0.004) 0.409 (0.ooo1) 1.ouO
5.277 3.982
0.046 0.024
2.044 2.159
-0.107 (0.213) l.ooo
- 0.003 (0.974) 0.308 (0.001) 1.0
4.489 2.620
0.048 0.026
2.667 2.606
1.000
- 0.288 (0.068) l.ooo
- 0.306 (0.078) 0.275 (0.116) 1.000
_.
DEVMEAN’
Correlations
MKTBOOK TAX
(N =
(N =
870)
870)
DEVMEAN (A’ = 893) Panel B: Keiretsu groups Mean Std. Dev. Correlations
MKTBOOK TAX
(N =
138)
l.GOO
(N = 138)
DEVMEAN (N = 114) Panel C: Non-rkeiretsu groups Mean Std. Dev. Corrt+ltion.s MKTBOOK (N =41) TAX (IV=41
1
DEVMEAN (n( =34)
AMarket-to-book value of common equity. h Income tax plus reserves for taxes, standardized by the total assets. ’ Mean standard deviation of analyst forecast for March 1988, 1989. and 1990 estimated December 1987. 1988, and 1989.
in
costs are lower in Japan. Thus, firms may have a preference for debt in their external financing decision. Since firms with good growth opportunities tend to need more external financing, they will tend to have higher debt ratios. An alternative explanation for the observed relationship may lie in the Ja firms’ preference for bank debt. If bank debt is always the preferred source of financing, growth firms with a greater need for external capital will accumulate a large amount 0 f debt in their capital struct
Our evidence also indicates that. contrary to the common belief of potentially unique behavior of keire~~trfirms from independent firms because of the stronger ties these firms have to banks and other financial institutions, there are no significant differences between keiretsu firms and non-keiretstr firms in terms of the measures of leverage, growth opportunities, firm size, and the investment opportunity set-financing decision relations. In addition, it is empirically shown that two other competing explanations, the information asymmetry theory and the tax models do not explain the observed positive relationship between corporate financing and the investment opportunities in Japan. We interpret these results to mean that investment opportunities are an in+ortant determinant of the Japanese firm’s financing policy. The direction of this relationship is not necessarily inconsistent with that predicted by the agency model of Myers ( 1977), Jensen ( 1986) and Stulz ( 1990).
References DeAngelo,H.
and R.W. Masulis, 1980, Optimal capital structure under corporate and personal taxation, Journal of Financial Economics 17, 3-29. Dhaliwal. D., R. Trezevant and S. Wang, 1992. Taxes, investment-related tax shields and capital structure, Journal of the American Taxation Association 14, l-2 1. Dotan. A. and S.A. Ravid. 1985. On the interaction of real and financial decisions of the lirm under uncertainty. Journal of Finance 40, 501--517. Frankel, J.. 1991, The Japanese cost of finance: a survey, Financial Managenent 20. 95 127. Gaver, J.J. and K.M. Gaver. 1993, Additional evidence on the association between the investment opportunity set and corporate financing, dividend and compensation policies. Journal of Accounting and Economics 16, 125- 160. Gerlach, M., 1992. Alliance patterns and the social organization of Japanese business (University of California Press, Berkeley). Givoly. D., C. Hayn, A. Ofer and 0. Sarig, 1992. Taxes and capital structure: evidence from firms’ response to the Tax Reform Act of 1986, Review of Financial Studies 5, 331-355. Hite. G.. 1977, Leverage, output effects and the M-M theorems, Journal of Financial Economics 14, I 77-202. Hoshi, T., A. Kashyap and D. Scharfstein, 1990a. The role of banks in reducing the costs of financial distress in Japan, Journal of Financial Economics 27, 67-88. Hoshi. T., A. Kashyap and D. Scharfstein, 1990b, Bank monitoring and investment: evidence from the changing structure of Japanese corporate banking relations, in: R. Glenn Hubbard, ed., asymmetric information, corporate linance, and investment (University of Chicago, Chicago, IL) 105 126. Hoshi, T.. A. Kashyap and D. Scharfstein, 1991, Corporate structure, liquidity and investment: evidence from Japanese panel data, Quarterly Journal of Economics 106, 33-60. Jensen, M., 1986, Agency costs of free cash flow. corporate finance and takeovers, American Economic Review 76. 323.-329. Jung, K.. Y. Kim and R. Stulz, 199,.3 Managerial discretion, investment opportunities, and the security issue decision, Working Paper (Ohio State University). Kcster, C., 1986, Capital and ownership structure: a comparison of United States and Japanese manufacturing corporations, Financial Management I 5, 5-- !6.
242
H. Jo ct nl. 1 Puc$c- Bush Finunc4 Jourrzal 2 ( 1994) 227-242
Kester, C., 1991, Japanese takeovers: the global contest for corporate control (Harvard University Press, Cambridge, MA). Lang, L. and R. Litzenberger, 1989, Dividend announcement: cash flow signalling vs free cash flow hypothesis?, Journal of Financial Economics 24, 18 1-192. Lewellen, W., C. Loderer and K. Martin, 1987, Executive compensation contracts and executive incentive problems: an empirical analysis, Journal of Accounting and Economics 9, 287-310. MacKie-h4ason, J., 1990, Do taxes affect corporate financing decisions?, Journal of Finance 45, 1471-1493. Myers, S.. 1974, Interactions of corporate financing and investment decisions - implications for capital budgeting, Journal of Finance 29. l-25. Myers, S., 1977, Determinants of corporate borrowing, Journal of Financial Economics 9, 147- 176. Myers, S. and N. Majiluf, 1984, Corporate financing and investment decisions when firms have information that investors do not have, Journal of Financial Economics 13, 187-221. Nakatani. Y., 1984, The economic role of financial corporate grouping, in: Aoki, M., eds, The economic analysis of the Japanese firm (North-Holland, Amsterdam). Opler, T. and S. Titman. 1991, The characteristics of leveraged buyout firms. Working Paper (University of California at Los Angeles). Pilotte, E.. 1992. Growth opportunities and the stock price response to new financing, Journal of Business 65, 37 l-394. Pinkerton, J.M. and A. Sarin. 1993, Financing decisions and the investment opportunity set, Working Paper (Virginia Polytechnic Institute and State University). Prowse, SD., 1990. Institutional investment patterns and corporate finance behavior in the U.S. and Japan, Journal of Financial Economics 27,43-66. Prowse. S.D.. 1992, The structure of corporate ownership in Japan, Journal of Finance 47, 1121-l 140. Smith. C-W. and R.L. Watts. 1992, The investment opportunity set and corporate financing, dividend, and compensation policies, Journal of Financial Economics 29, 263-292. Stulz. R. 1990. Managerial discretion and optimal financing policies, Journal of Financial Economics 26, 3-27. Titman. S. and R. Wessels. 1988. The determinants of capital structure choice, Journal of Finance 43, 1 - 19. Trezevant. R.. 1992. Debt financing and tax status: tests of the substitution effect and the ta;; exhaustion hypothesis using firms’ responses to the Economic Recovery Tax Act of 198 1, Journal of Finance 47. 1557- 1568.
Pacific-Basin
Finance Journal
2 (1994) 227-242
Financing decisions and the investment opportunity set: Some evidence from Hoje Jo *a, John M. Pinkerton b and Atulya Sarin a ’ Leavey
Schoolof Business,
Santa Clara
Unirersity, Santa Clara, CA 950.53, USA b R.B. Pantplin College of Business, Virginia Po.‘ytechnic lnstitute and State Utukersity, Blacksburg, VA 24061, USA
Abstract
This paper examines the empirical reiation between corporate financing and investment opportunities in Japan. In contrast to the findings in U.S. firms, we find that for a sample of 1,044 Japanese firms with data available on Pa&EC-Basin Capital Markets (PACAP) database over the period 1986-1990, there is a positive relationship between book debt-equity ratios and our measure of investment opportunities. These results are consistent with the joint hypotheses that the negative relationship found in the U.S. is because of agency conflicts and these conflicts are mitigated in Japanese firms because of their institutional arrangements. We also document that contrary to the common belief of potentially unique behavior of keiretsu firms because of their stronger ties to banks and other financial institutions, there are no significant differences between keiretsu firms and independent firms leverage, growth opportunities, firm size, and the relationship between investment opportunities and financial decisions. Key words: Financing decisions; Investment
opportunity
set; Agency model; Keiretsu
JEL classification: G32 _
__~~_.~___
__-
___.
1. Introduction
It is well-documented
that
there
is a negative
association
between
debt
* Corresponding author. Tel. (408) 554-4385. We are extremely thankful to David Denis, Ghon Rhee, and Sheridan Titman for providing insightful comments and suggestions. We would like to thank Lynch, Jones and Ryan Co. for providing the analyst forecast data. This work has been partially supported by research grants from Leavey School of Business. This paper received the Chicago Board Options Exchange Competitive Research Award. 0927-538X/94/$07.00 I(‘I 1994 tllsevier Science SSI)f 0927-538X(93)0001 6-Z
.v. AH rights reserved
228
H. Jo et a!. / Pacific-Basin Finance Journal 2 ( 1994) 227-242
levels and investment opportunities in U.S. firms! This relationship is consistent with at least two alternative theoretical frameworks. One argument is that agency conflicts cause firms with an abundance of positive NPV investment opportunities to issue equity rather than debt to finance their new investment. For example, Myers (1977) points out that the stockholders of firms with a high chance of bankruptcy are unlikely to provide new capital, even to finance positive NPV projects. The stockholders’ reluctance to invest more in the financially distressed firm stems from the reality that, while they bear the entire cost of the investment, the existing debt-holders capture most of the investment’s return. Thus, when facing financial distress, a company’s existing large debt level provides the firm’s stockholders an incentive to reject positive NPV projects. Myers concludes that firms not facing financial distress but expecting positive NPV investment opportunities will prefer to maintain low levels of debt to finance their current positive NPV projects with equity. Also, Jensen (1986) and Stulz (1990) argue that managers have an incentive to invest all available funds even if it requires investing in some negative NW projects. Debt service payments reduce the amount of funds managers have at their discretion for profitable investments. Thus, the managers of firms expecting to have positive NPV investment opportunities prefer to finance those opportunities with equity. Only when positive NPV opportunities diminish and free cash flow increases will managers use debt. The alternative explanation is based on the tax code provisions originally pointed out by DeAngelo and Xasulis (1980) and Dotan and Ravid (1985). They argue that positive NPV investments create non-debt tax shields and since debt related and investment related tax shields are perfect substitutes, the incentive for debt financing disappears as positive NPV investment opportunities increase. Thus growth firms should, at the margin, be financed by less debt. MacKie-Mason ( 1990) and Dhaliwal et al. (1992) show that taxes play an important role in the firm’s capital structure decision. Specifically, they show that the effect is more pronounced to firms which have a substantial probability of losing the deductibility of tax shields. Using a tax law change, Trezevant ( 1992) also finds that an increase in non-debt tax shields leads to a decrease in leverage and interprets this evidence as an empirical support for the substitution effect and the tax exhaustion hypothesis. The findings of Givoly et al. (1992) further indicate that there exists a substitution effect between debt and nondebt tax shields, and that both corporate and personal ’ The investment opportunity set is typically characterized as the proportion of firm value represented by growth options and is measured by the market-to-book value of equity. Smith and Watts (1992). Jung et al. (1992). Gaver and Gaver (1993), and Pinkerton and Sarin (1993) found a negative relation between debt ratios and the market-to-book value of equity.
H. Jo et d.
1
Puc$c-Busin
Finance Journul 2 ( 1994) 227-242
229
tax rates affect leverage decisions. They also find a positive association between changes in leverage and changes in corporate taxes, thus supporting the tax-based theories of capital structure. In this paper, we attempt to determine which of these explanations, agency or taxes, is the dominant reason for this observed relationship between investment opportunities and financial policy. We do so by examining the same relationship in the Japanese market, where the tax code provision is similar to the U.S., but the agency conflicts are mitigated to a larger extent. Japanese financial institutions are allowed to take large positions in the debt and equity of the same firm. Most U.S. financial institutions are not. This difference affects the degree to which these large investors can reduce the inherent principal-agent conflict between the shareholders and debtholders of the firms. Also, large equity stakes by Japanese financial institutions and their active monitoring of corporate policy reduces the agency conflict between owners and managers by controlling managers’ consumption of perquisites and by reducing their scope to pursue goals other than profit maximization. Prowse (1990) finds that Japanese financial institutions take large equity positions in firms more susceptible to the agency problem. Also debt ratios of U.S. firms are negatively related to the firm’s potential to engage in risky suboptimal investments, whereas Japanese debt ratios show no such relation. He concludes that this evidence is consistent with the notion that the agency problem is mitigated to a greater degree in Japan than in the U.S. Gerlach (1992) also indicates that the seemingly clear categories of principal and agent become blurred due to the reciprocal relationships as the managers of one firm become the owners of another, and in turn are held by managers of that firm. If indeed agency reasons cause the negative relationship between investment opportunities and leverage found in the U.S. and the institutional arrangements in Japan mitigate the agency problems, we expect Japanese firms to not show a negative relation between leverage and measures of investment opportunities. Alternatively, if tax reasons are the dominant cause for this association, we expect the relationship to persist in Japan. Thus, we examine the relationship between investment opportunities and leverage for a sample of Japanese firms to identify the major determinant for this relationship. We find that for our sample of 1044 Japanese firms over the period 19861990, there is a positive relation between the book debt-equity ratio and our measure of investment opportunities. We further examine the relationship after partitioning our sample as keiretsu firms or non-keiretsu firms. Recent studies indicate that differences between keiretsu and independent firms are large enough to yield observable differences in behavior. However, we find that our results are invariant to this classification. We interpret our evidence
as support for the agency models of capital structure of Myers (1977), Jensen (1986) and Stulz ( 1990). The remainder of the paper is organized as follows. In section 2 we discuss the relationship between financing policy and investment opportunities. Section 3 documents taxes, information asymmetry and investment opportunities. The paper ends with a conclusion in Section 4.
2. Relationship between financing policy and investment opportunities 2.1. San@
6kscrip tion
The sample data consist of all Japanese companies listed on the 1992 tape compiled by the Pacific-Basin Capital Markets (PACAP) Research Center at the University of Rhode Island that have complete annual observations between March 1986 and March 1990. To remain in the sample, each firm must have a March year end2. To investigate the relation between financing policy and the invest.ment opportunity set for Japanese firms, we delete financial institutions and public utilities from the sample to avoid the confounding effects of regulation on corporate financing decisions. This leaves us with our sample of 1044 firms. We measure the following variab!es for financing policy and investment opportunities over the period 19861990. Financing decisions are measured by using the debt-equity ratio. We compute four versions of this ratio. The first two versions are total debtequity ratios used by Gaver and Gaver (1993): book total debt-equity and market total debt-equity. The book total debt-equity ratio is total debt divided by total common equity plus preferred stock. The market total debtequity is total debt divided by the market value of common equity plus the book value of preferred stock. The last two versions are long-term debtequity ratios suggested by Titman and Wessels (1988). They argued that agency costs are likely to be higher for firms in growing industries, which have more flexibility in their choice of future investments and that expected future growth should thus be negatively related to long-term debt levels. The historical (book) long-term debt-equity ratio is long-term debt divided by book value of common equity plus book value of preferred stock. The market long-term debt-equity ratio is long-term debt divided by market value of common equity plus book value of preferred stock. Since the market debt-equity ratios are sensitive to share price while the book debt--equity ratios are not, we view the book debt-equity ratios as our primary measures
’ WC require the firms to have the same fiscal year end so that our estimations
of mark:
value
of financing. However, to keep comparability Jvith Smith and Watts (1992) and Gaver and Gaver (1993), we also examine the market debt-equity ratios. The next step is to estimate growth opportunities. We use the market-tobook value of common equity ratio (MKTBOOK) following Lewellen et al. (1987) and Gaver and Gaver (1993) as our primary measure of growth opportunities”. Gaver and Gaver (1993) use MKTBOOK to classify firms as growth and non-growth firms. However, we use the continuous variable of growth opportunities rather than dichotomized growth and non-growth firms because a continuous spectrum can provide broader information on growth opportunities and can avoid the arbitrary classification of growth and nongrowth firms. The market-to-book equity ratio is calculated as: MKTBOOK =(Closing price per share x Number of shares outstanding)/total common equity with all variables measured at the fiscal year end. All firms with negative book value of equity are deleted from the sample. Although the nature of the relation between the investment opportunity set and firm size is not well understood, Smith and Watts ( 1992) indicated that the greater diversification of larger firms enables them to have larger debt capacity and therefore hig..kl her debt+quity ratios than smaller firms to the extent that costs of financial distress limit leverage. Because of this reason, Smith and Watts ( 1992) Jung et al. ( 1992), Gaver and Gaver ( 1993) and Pinkerton and Sarin ( 1993) use firm size as a control variable. We also include firm size (measured as the natural log of total assets) as an explanatory variable in our analysis.
2.2. Result
Table 1 presents means, standard deviations and Pearson correlation coefficients for our variables of interest. For 1044 Japanese firms for which this information is collected, Table 1 reveals that the average book total debt-equity is 3.94 (equivalent to debt ratio of 79.76:,<) and market total debt-equity ratio is 0.87 (equivalent to debt ratio of 46.527,~). As expected, all four versions of debt-equity ratios are highly correlated with each other and with firm size. These high correlations with the firm size variable could result in a spurious relationship between debt-equity ratios and investment oppor-
3 Although there is no single, universally accepted, empirical proxy for the investment opportunity set, the market-to-book value of shareholders’ equity ratio and the market value of the firm to the book value of assets ratio are widely used as primary measured of the growth opportunity. Lang and Litzenberger (1989) used Tobin’s Q to proxy for a firm’s expected investment opportunities in future periods. Pilotte (1992) used dividend policy, growth rates of the market value of equity, sales, net operating income, and total assets as proxies for growth opportunities. Without doubt, any classification schene is likely to contain error.
Table 1 Descriptive statistics and Pearson correlation coefficients. Summary statistics including means, standard deviations, and Pearson correlation coefficients for the sample of 1044 Japanese Industrial firms. P-values are in parentheses _____~__~__.__--_
_ _.. ~- _--.-
BDE
MDE
BLDE
MLDE
MKTBOOK
ASSET x 10”
Mean
3.94
0.87
0.56
0.09
4.89
1.85
Std. Dev.
5.91
0.97
2.10
0.20
4.34
5.42
1.00
0.63 to.001
0.78 (0.00)
0.58 (0.00)
0.56 (0.00)
0.11 ww
1.00
0.29 (0.00)
0.74 (0.00)
-0.01 (0.74)
0.24 (0.00)
1.00
0.57 (0.00)
0.52 (0.00)
0.07 (0.02)
1.00
0.15 (0.00)
0.28 (0.00)
1.00
0.00 (0.97)
Correlations Book Debt-equity” (BDE) Market Debt-equityb WDE) Book Long-term Debt-equity Market Long-term Debt-quity
(BLDE)’
( MLDE)d
MKTBOOK’ ASSETxlO! “
1.00
’ Book debt+quity = total debt divided by the book value of common equity plus the book value of preferred stock. h Market debt-equity = total debt divided by the market value of common equity plus the book value of preferred stock. ’ Long-term debt divided by the book value of common equity plus the book value of preferred stock. d Long-term debt divided by the market value of common equity plus the book value of preferred stock. ’ MKTBOOK = market-to-book value of common equity. f In Japanese yens.
(unities. Thus, as argued above, in order to prevent the potentially spurious relationships, we include the firm size variable in our regression. Capita! st r uctuse changes are lumpy and relatively infrequent causing the debt ratio at a particular point in time to be higher or lower than the optimal levels. To account for any measurement error which may arise because of that, we use the average of each variable including debt-equitv ratios over the five years of 19861990. Previous researchers such as Smith and Watts (1992), and Gaver and Gaver (1993) have typically examined only debt/asset or debt-equity ratios, which at a particular point in time reflect ulativc result of years of separate decisions. Such tests based on a
Table 2 Parameter estimate of cross-sectional regressions. Estimates of cross-sectional regressions relating the debt-equity ratio to investment opportunities and firm size for a sample of 1044 Japanese firms with data available on PACAP database over the period 1986-1990. The dependent variable in: model { 1) is historical (book) total debt-equity ratio (book value of total debt divided by book value of common equity plus book value of preferred stock), model (2) is market total debt-equity ratio (book value of total detl divided by market value of common equity plus book value of preferred stock), model (3) is historical (book) long-term debt-equity ratio (long-term debt divided by book value of common equity plus book value of preferred stock), model (4) is market long-term debtequity ratio (long-term debt divided by market value of common equity plus book value of preferred stock). T-statistics are in parentheses
Independent Intercept MKTBOOK” LASSETSb Adjusted R’ F-value (Prob > F)
variables
Model ._.____~ (1)
_.~____-~ (2) ------ 13.79 - 3.94 ( - 4.87**) (-7.21**) 0.78 - 0.02 (22.51**) (-0.31) 0.56 0.19 (4.95**) (8.85**) 0.33 0.07 258.88 39.19 (o.oo**)
(o.oo**)
__-__ (3)
.-___
- 3.36 (-3.21**) 0.25 (19.95**) 0.11 (2.57*) 0.28 70.53 (o.oo**)
(4) --.. ~_ _ -_ - 0.95 ( - 8.35**) 0.01 (5.87**) 0.04 (8.89”“) 0.09 53.24 (o.oo**)
a MKTBOOK
= market-to-book value of common tquity. b LASSETS = natural log of total assets. *Significantly different from zero at the 5 percent level. **Significantly different from zero at the 1 percent level.
cumulative financing measure are likely to have lower statistical power for identifying a potentially time-varying optimal leverage ratio. Table 2 presents results of cross-sectional regressions relating leverage, variables to our measure of investment opportunities (MKTBOOK) and firm size (LASSETS) for a total sample of 1044 Japanese firms with data available on PACAP database over the 1986-1990 period. The dependent variable in: model ( 1) is historical (book) total debt-equity ratio (book value of total debt divided by book value of common equity plus book value of preferred stock), model (2) is market total debt-equity ratio (book value of total debt divided by market value of common equity plus book value of preferred stock), model (3) is historical (book) long-term debt-equity ratio (long-term debt divided by book value of common equity plus book value of preferred stock), model (4) is market long-term debt-equity ratio (long-term debt divided by market value of common equity plus book value of preferred stock). The results reported in Table 2 show that the book total debt-equity ratio and book long-term debt ratio are significantly positively related to investfirms of a gs a ment opportunities. This is contrary to the fi
negative relationship. The relationship between market long-term debt ratio and investment opportunities is significantly positive which is also contrary to what has been argued by Xtman and Wessels (1988) for U.S. firms. However, the market debt-equity ratio is sensitive to share price. Specifically, firms with high (low) share price will have a low (high) market debt--equity ratio and a high (low) market to book ratio. This would lead to a spurious relationship between the financing policy and our measure of investment opportunities. This should bias the coefficient to be negative, yet it is still positive in model (4). Therefore, 2s stated earlier, we view the book debtequity ratio as our primary measure of financing policy. We also make two other observations from this Table. First, when book ratios are used as the dependent variable, the estimated coefficients on both explanatory variables are larger (in absolute value) and the regressions have a higher adjusted I?‘. This implies, that the book ratios are better explained by our theories of capital structure. Secondly, all four versions of debt-equity ratios are positively related to the firm size variable. Perhaps, as Smith and Watts ( 1992) indicated, this is because the greater diversification of larger firms enables them to have higher leverage than smaller firms to the extent that costs of financial distress limit leverage. This positive correlation between debt-equity ratio and firm size in Japanese tirms is consistent with earlier U.S. evidence reported by Smith and Watts (1992). Jung et al. (1992). Gaver and Gaver ( 1993), and Pinkerton and Sarin ( 1993).
2.3. KtGrc*tstr and independent firms The Japanese capital markets and corporations possess institutional arrangements that differ from the U.S. One of the important institutional features of Japanese firms is that many Japanese firms belong to keirefsu - for example. Mitsubishi, Mitsui, Sumitomo, Fuji, I&i-ichi Kangyo, groups Sanwa, and Tokai among others - in which some groups have a large commercial bank at the center and bank-affiliated firms receive substantial debt and equity financing from the bank. The terminology of keiretstr is typically used to refer to two different sets of relationships: vertical groupings of upstream supplier firms and downstream distributors affiliated with a large manufacturing or commercial enterprise and diversified groups called ‘horizontal’ kviretsu following Japanese terminology of _&XI keirvtsu by some observers, comprising a commercial bank and other financial institutions. one or more trading companies, and a range of large manufacturing firms. Even nob-kuirt~su groups may contain many of the similar institutional features as those more clearly defined as kriwtszr. Firms such as Toyota or Hitachi carry out most of their usiness with vertically or horizontally linked suppliers and dis-
tributors. For example. Toyota sits on the presidents’ council of the Mitsui grout. while Hitachi sits on the presidents’ councils of the Fuji, Sanwa, and Dai-Ichi Kangyo Bank groups. Recent studies indicate that differences between keiru~r and independent firms are large enough to yield observable havior. For ifferences in example, Hoshi et al. (1990a. 1991) report that keirets~ firms’ investments are less liquidity-constrained than are independent firms because of their closer ties to a major creditor and the lower cost of debt financing. Prowse ( 1992) also suggests that kuirerstr firms differ from independent firms that have more arms-length type relationships with other firms and financiers. These dif’ferences in institutional arrangements may influence the Japanese firms’ financing decisions and the behavior of shareholders as monitors. Gerlach ( 1992) also notes that close relationships among banks, shareholders, and business partners associated with keiretsu groups are seen as a potential source of Japanese competitive advantage, particularly in channeling the activities cf corporate man agers in the direction of long-term growth and profitability. Thus, we expect some potential differential behavior in financing policy, growth opportunities, or the investment opportunity-financing decision relations between keiretsu firms and independent firms. To examine this potential difference between keiretsu firms and independent firms, we attempt to classify Japanese firms into keiretsu groups and non-keirersu groups. Kester ( 1991) defines the Japanese keiretsu as a group of companies federated around a major bank, trading company, or large industrial firm. However, determining which firms are afftliated and which are independent is somewhat difficult. Following Hoshi et al. ( 1990a,b, 199 1) and Prowse ( 1990. 1993, we chose Nakatani’s ( 1984) classification scheme because it focuses on the strength of a firm’s relationship to the financial institutions in the group: the propensity to borrow from group banks and insurance companies and the percentage of shares held by other group firms. Using Nakatani’s ( 1984) classification for our sample, we are able to classify 171 firms as keiretsu and 48 firms as non-keiretsu. We provide the results of a Wilcoxon signed-rank test between 171 keiretsu firms and 48 non-keiretsu firms in terms of financial policy, growth opportunities, and firm size in Table 3. The comparison between keirutsu firms and non-keiretsu firms during the 1986-1990 period reveals that the book debtequity. market debt-equity, book long-term debt-equity, market long-term debt-equity, market-to-book ratio (MKTBOOK), and firm size measured as total assets (ASSET) are not significantly different between keiretsu and independent firms based on the Wilcoxon signed-rank test, although the absolute values for the medians and the means of book debtequity, market debt-equity, book long-term debt-equity, market long-term debt-equity, and MKTBOOK in keiretsu firms are larger than those of nonkeirefsu firms. In contrast with recent studies that indicate potentially large
H. Jo et al. / Puc@Basin
236
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( 1994) 227-242
Table 3 Wilcoxon signed-rank test between keiretsu firms and independent firms. A comparison between 171 kerretsu firms ;;I:’ 4.2 independent firms in terms of linancial policy measured by debt-equity ratios, growth opportunities measured by market-to-book value of equity (MKTBOOK), and firm size measured by total assets (ASSET) with data available on the PACAP database over the period 1986-1990 Keiretsu groups (N= 171)
Non-keiretsu (N=48)
groups
Wilcoxon prob.”
Mean
Median
Mean
Median
Book Debt-equityb
3.41
2.35
2.69
1.96
0.13
Market Debt-equity’
0.77
0.61
0.64
0.51
0.25
Book Long-term Debt-equityd
0.43
0.09
0.27
0.05
0.09
Market Long-term Debt-quit!’
0.09
0.03
0.06
0.02
0.10
MKTBOOK’
4.79
3.95
4.29
3.49
0.21
ASSET x 10’ ‘g
2.72
1.08
2.52
0.87
0.65
“The probability that the absolute value of the Wilcoxon signed rank z-statistic for keiretsu groups is different form the absolute value of the observed -?-statistic of non-keiretsu groups. b Book debt-equity= total debt divided by the book value of common equity plus the book value of preferred stock. Market debt-equity= total debt divided by the market value of common equity plus the book value of preferred stock. d Long-term debt divided by the book value of common equity plus the book value of preferred stock. ‘Long-term debt divided by the market value of common equity plus the book value of preferred stock. ’ MKTBOOK = market-to-book value of common equity. 8 In Japanese yens.
differences between keiretsu and independent firms in terms of observable differences in behavior, we find that these firms are similar”. In order to see whether there is any difference between keiretsu firms and non-keiretsu firms for the relationship between investment opportunities and leverage, we display the results from the OLS estimation of further crosssectional regressions, in which we add a dummy variable (one for kvirvtsu firms and zero for non-keiretsu firms), and an interaction term between the dummy variable and MKTBOOK in Table 4. oshr et al.
( 199l)
and Prowse
( 1992).
Table 4 Parameter estimate of further cross-sectional regressions. Estimates of further cross-sectional regressions relating the debt-equity ratio to investment opportunities, firm size, dummy variable (one for keiretsu firms and zero for non-keiretsu firms), and interaction variable for a sample of 171 keiretsu firms and 48 non-keiretsu firms with data available on PACAP database over the period 19861990. The dependent variable in: model (1) is historical (book) total debt-equity ratio (book value of total debt divided by book value of common equity plus book value of preferred stock), model (2) is market total debt-equity ratio (book value of total debt divided by market value of common equity plus book value of preferred stock), model (3) is historical (book) long-term debt-equity ratio (long-term debt divided by book value of common equity plus book value of preferred stock), model (4) is market long-term debt-equity ratio (long-term debt divided by market value of common equity plus book value of preferred stock). T-statistics are in parentheses Model Independent Intercept MKTBOOK” LASSETSb
variables
(1) 11 d.29 ( - 2.14’) 0.72 (4.31**) 0.39 (2.13*)
DUMMY
-092 (-1.00)
DUMMY x MKTBOOK
- 0.26 ( - 1.47)
Adjusted R2 F-value ( Pro b > F)
(2)
(3)
-2.51 ( - 2.43’)
- 3.55 ( - 2.82*)
- 0.89 ( - 3.19**)
- 0.04 (1.07)
0.09 f 2.05*)
0.01 ( 1.43)
0.14 (2.81**)
0.04 (3.29**)
0.12 (2.99**) 0.22 ( 1.08) - 0.02 ( - 0.60)
-0.25 (-0.01) 0.08 ( 1.59)
0.49
0.03
0.27
52.62
2.78 (0.03*)
21.01
(o.oo*)
(4)
(o.oo**)
0.05 (0.99) i
-0.01 - 0.56) 0.05 3.77 (o.ol**)
a MKTBOOK = market-to-book value of common equity. b LASSETS = natural log of total assets. * Significan tl y different from zero at the 5 percent level. **Significantly different from zero at the 1 percent level.
The outcomes reported in Table 4 confirm the positive association of book debtequity ratios and investment opportunities, positive correlation between debt-equity ratios and firm size variable, and higher adjusted R2 under book debt-equity regressions. However, when market ratios are used as dependent variables, the estimated coefficients become insignificant. In addition, more importantly, we found that the estimated coefficients of dummy variables and interaction terms under all four regressions are insignificant. This implies that the relationship between investment opportunities and financing choices of Japanese firms are similar for both kriwtsu firms an
3. Taxes, information asymmetry, and investment opportunities Our previous results are consrstent with the joint hypotheses that the negative relationship found in the U.S. is because of agency conflicts and these conflicts are mitigated in Japanese firms because of their institutional arrangements. However, the same results could be because of other differences in the Japanese market. First, the level of information asymmetry may be higher in Japan. The pecking order theory of financing associated with the information asymmetry model of Myers and Majiluf (1984) predicts firms will finance new investment, first internally, then with debt (then with convertible bonds), and finally, as a last resort, with equity. If the level of information asymmetry is higher in Japan, growth firms with greater needs for external capital will be more reluctant to issue equity because of greater potential for wealth transfer to new shareholders and will have greater amount of debt in their capital structure to reduce the adverse selection costs. This will lead to a positive relationship between investment opportunities and leverage. In fact, Kester (1986) reports that the Tokyo Stock Exchange seems to exhibit characteristics symptomatic of information asymmetries that might foster a reluctance on the part of firms to raise equity capital publicly. It should not be ignored, however, that such potential information asymmetry is not likely to be severe between firms and their main banks. We believe that as far as an information effect on capital structure is concerned, such close relationships between lenders and borrowers in Japan should reinforce a preference for bank debt. Second, the tax advantage of debt may be higher fz Japan thereby offsetting the agency costs of debt. Indeed, the tax models of Myers (1974) and Hite (1977) predict that the higher expected taxable income associated with positive NPV investment opportunities provides incentive to obtain the tax shields associated with debt financing. Thus, firms needing external capital will prefer debt even though the agency conflicts still persist. Regarding 3apanese corporate taxation, the Japanese Diet approved a tax reform which cut the Japanese corporate tax rate from 42’.‘~to 37.5”/; in December 1988. This left the Japanese tax rate only slightly higher than the current rate of 34”,, in the U.S. Frankel (1991) in his survey, concluded that by now little is left of the Japanese tax advantage and many other studies conclude that taxes are at best of second-order importance in comparing the capital structure between the U.S. and Japan. If either the higher information asymmetry or higher tax advantage of debt was causing our observed relationship, we would expect them to be positively correlated to our measure of growth opportunities. We9 along the line of Opler and Titman ( 1991) use divergence of analysts’ opinions as our proxy of information asymmetry. Data required to measure divergence of analysts’ opinions during the 1987-1990 period is obtained
from the Institutional Brokers Estimate System (I,‘B,;“E/S) provided by I/B/ES incorporated. This database reports detailed surve;’ da!? a,! dnalysts’ forecasts of firms annual earnings. We measured divergence of analysts’ opinions by the mean standard deviation of analysts’ forecasts. In particular,
as our data of information asymmetry available start from fiscal year 1988, we estimate mean standard deviation of analysts’ forecasts (D~~~EA~) for March 1988, 1989, and 1990 estimated in December t , and 1989. The analysis of correlation between investment opportunities and our proxy of information asymmetry is based on 870 firms that have complete data from two data sources (PACAP database and I/B/E/S database) for the 1987-1990 period. Data for tax measure (TAX) is obtained from PACAP database and TAX is estimated as income tax plus reserves for corporate
taxes and business taxes, standardized by the total assets. The correlation among investment opportunities, the level of information asymmetry, and the tax advantage of debt are presented in Table 5. As argued above, if information asymmetry is causing the observed relationship between investment opportunities and leverage, we expect growth to be positively correlated with our proxy of information asymmetry similarly for the tax effect. However, Table 5 shows that investment opportunities are negatively (insignilicantly) related to both information asymmetry and tax advantage of debt for the total sample reported in Panel A (keiretsu firms and non-keiretsu lirms reported in Panels B and C). This evidence indicates that neither the level of information asymmetry nor the tax advantage of debt is causing the positive relationship between the investment opportunities and debt-ratios. This provides additional evidence that the positive relationship between financing decisions and investment opportunities found in Japanese firms is because of mitigated agency problems due to their institutional arrangements.
4. Conclusions This paper has examined the empirical relation between corporate financing and the investment opportunities in Japan. In contrast to the findings in U.S. firms, we find that among Japanese firms there is a positive relationship between book debt-equity ratios and our measure of investment opportunities. These results are consistent with the joint hypotheses that the negative relationship found in the U.S. is because of agency conflicts and these conflicts are mitigated in Japanese firms because of their institutional arrangements. However, our analysis does not provide a formal explanation why the relation of investment opportunity set-financing decisions in Japan is positive. One possible explanation for the positive relationship is that bankruptcy
H. Jo YI til. / Pucijic. Bush Finunce Jorrrnal .? ( 1994) .?.?7-?4.?
240
Table 5 Mean, standard deviations, and Pearson correlation coeficients. This table reports means, standard deviations, and Pearson correlations for tax, growth opportunities (MKTBOOK), and information asymmetry (DEVMEAN) variables. Due to the difference in data availability (Tax and MKTBOOK from PACAP database and DEVMEAN from I/B/E/S tapes), number of each variable is different Explanatory
Panel A: Total sample Mean Std. Dev.
variable
MKTBOOK~
TAXb
5.039 3.929
0.047 0.029
2.707 4.803
1.W
-0.162 (0.0001) 1.000
-0.127 (0.004) 0.409 (0.ooo1) 1.ouO
5.277 3.982
0.046 0.024
2.044 2.159
-0.107 (0.213) l.ooo
- 0.003 (0.974) 0.308 (0.001) 1.0
4.489 2.620
0.048 0.026
2.667 2.606
1.000
- 0.288 (0.068) l.ooo
- 0.306 (0.078) 0.275 (0.116) 1.000
_.
DEVMEAN’
Correlations
MKTBOOK TAX
(N =
(N =
870)
870)
DEVMEAN (A’ = 893) Panel B: Keiretsu groups Mean Std. Dev. Correlations
MKTBOOK TAX
(N =
138)
l.GOO
(N = 138)
DEVMEAN (N = 114) Panel C: Non-rkeiretsu groups Mean Std. Dev. Corrt+ltion.s MKTBOOK (N =41) TAX (IV=41
1
DEVMEAN (n( =34)
AMarket-to-book value of common equity. h Income tax plus reserves for taxes, standardized by the total assets. ’ Mean standard deviation of analyst forecast for March 1988, 1989. and 1990 estimated December 1987. 1988, and 1989.
in
costs are lower in Japan. Thus, firms may have a preference for debt in their external financing decision. Since firms with good growth opportunities tend to need more external financing, they will tend to have higher debt ratios. An alternative explanation for the observed relationship may lie in the Ja firms’ preference for bank debt. If bank debt is always the preferred source of financing, growth firms with a greater need for external capital will accumulate a large amount 0 f debt in their capital struct
Our evidence also indicates that. contrary to the common belief of potentially unique behavior of keire~~trfirms from independent firms because of the stronger ties these firms have to banks and other financial institutions, there are no significant differences between keiretsu firms and non-keiretstr firms in terms of the measures of leverage, growth opportunities, firm size, and the investment opportunity set-financing decision relations. In addition, it is empirically shown that two other competing explanations, the information asymmetry theory and the tax models do not explain the observed positive relationship between corporate financing and the investment opportunities in Japan. We interpret these results to mean that investment opportunities are an in+ortant determinant of the Japanese firm’s financing policy. The direction of this relationship is not necessarily inconsistent with that predicted by the agency model of Myers ( 1977), Jensen ( 1986) and Stulz ( 1990).
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