Investigating the Nonlinear Relationship between ...

Asian Research Consortium Asian Journal of Research in Banking and Finance Vol. 4, No. 11, November 2014, pp. 162-168.

Asian Journal of Research in of Research in and Banking and Finance

ISSN 2249-7323

www.aijsh.org

Investigating the Nonlinear Relationship between Financial Leverage and Capital Intensity: Empirical Evidence from Companies Listed in Tehran Stock Exchange Esmail Tavakolniaa, Asghar Ramezanib, Afsoun Hazratib a

Ph.D. Student of Accounting in Mazandaran University, Babolsar, Iran Lecturer in Kooshyar Higher Education Institute, Rasht, Iran Email: [email protected] b M.A. Student of Finance in Kooshyar Higher Education Institute, Rasht, Iran DOI NUMBER-10.5958/2249-7323.2014.01444.8

Abstract Financial leverage plays a decisive role as an important tool in corporate finance and the capital structure in investment decisions. In this study, the ratio of total debt to total assets is used as a measure of financial leverage, and fixed assets to total assets ratio as an independent variable, a measure of capital intensity has been considered. The samples used in this study consisted of 111 companies listed in Tehran Stock Exchange during the period 2007 to 2012 and regression between variables is used for hypothesis test. This paper suggests a non-linear relationship between capital intensity and financial leverage of companies listed in Tehran Stock Exchange.

Keywords: Financial Leverage, Investment in Fixed Assets, Financing Using Debt, Non-linear Relationship

162

Tavakolnia et al. (2014). Asian Journal of Research in Banking and Finance, Vol. 4, No. 11, pp. 162-168.

1. Introduction Expanding scope of business units and corporate development, create new liquidity needs which can be provided by internal sources including retained earnings or legal reserve or from outside sources, including interest-bearing debt. A company which does not have any debt, its capital structure represents equity, and since most of the corporate capital structure are mix of debt and equity and use of external sources because of capital costs and amount of interest or dividends, benefits and risks, Financial managers are very sensitive and accurate to get a loan, and maximizing shareholder wealth. In other words, one of the main challenges of financial management is capital structure and capital structure effect on the market value of company and also on liabilities and capital costs. This study is an attempt to identify potentially nonlinear relationship between financial leverage and capital intensity of companies listed on Tehran Stock Exchange.

2. Problem Statement Given the importance role of financial leverage, it is possible to investigate the relationship between capital intensity, control strategies and guidance to identify the most important ingredient. Although numerous studies have been done on the relationship between financial leverage and capital intensity, but with careful consideration, it can be concluded that these studies have not been summarized in a specific field and in some cases, the results are contradicted. For this reason, this research seeks to answer the question that whether there is non-linear relationship between access to the financing by debt and capital intensity? Thus, in this research, both scientific and practical goal is being pursued. Explaining the nonlinear relationship between financial leverage and capital intensity as a theoretical basis, are considered as scientific aim of study. The purpose of this study was also primarily functional needs of capital market participants, financiers, corporate executives, and the other individuals and entities that somehow, their decisions are taken in relation to corporate performance. 3. Literature Review First time, Modigliani and Miller (1958) in an article entitled "cost of capital, corporate finance and investment theory" came to the conclusion that there is no relationship between capital structure of company and company's future performance. But a few years later in an article in 1963, taking into account the income tax, they have revised their theory. Because of tax advantages for companies which is create by financial leverage, they argued that companies in order to finance use borrowing, because it will eventually enhance the company's value. Greene (1984) in his research has concluded that investment decisions are not independent from financing decisions and financial leverage may lead to inappropriate incentives for investment. Financing by debt reduce incentives of managers and shareholders to invest in projects with high value. Brealey and Myers (1984) and Shapiro and Titman (1986) in their study concluded that further investment in fixed assets increases the company's risk. In contrast, Hurdle (1974), Lubatkin and Chatterjee (1994) and Barton (1998) argued that capital intensity can reduce company’s risk. Long and Malitz (1983), Anderson (1990) and Low et al (1994), utter that since the consequences of financial leverage is greater than the benefits that consequences can be reduced by investing in fixed assets, Because return of fixed assets may reduce cost of debts. However, these assets can be used as collateral to finance the debt. Brigham and Gapenski (1996) criticized the Modigliani and Miller's theory as it is considered invalid in the real world. Because in real world, by increasing financial leverage and debt levels, firms will face bankruptcy costs. Thus they concluded that the optimal capital structure is only possible if the tax shield advantage of debt don’t increases bankruptcy costs.

163


Long et al (1996) analyzed a sample of industrial firms in America in years 1970 to 1989. Discussion was mainly on the issue that leverage weakens incentives to invest in projects. They showed in their paper in firms with weak growth opportunities, leverage, and investments in future, there is negative relationship. But companies that have high growth and cash flow, leverage provides less constrained investment. Since companies with strong growth prospects, can easily re- finance in the capital markets. Shale (1994) and Tang and Zhang (2007) performed experimental tests and analysis, reports positive effect of financial leverage on capital intensity in the United States mining companies and industry. Setayesh et al (2011) in a study review factors affecting financial leverage from agency theory perspective. In this study, the linear regression equation of sixteen, eight coefficients and t-statistics as capital intensity (fixed assets to total assets ratio) was introduced, negative and eight were positive. Namazi and Shirzad (2005) argued that in general there is a positive relationship between capital structure and profitability, but this relationship is statistically weak and relationship between capital structure and profitability depends on industry. Ahn et al (2006) investigated relationship between investment and leverage. They showed that various investment firms, firms with higher financial leverage investments are concentrated. Kimiyaghari and Eynali (2008) suggest that according to the theory of the hierarchy of financing options, with an increase in tangible assets, there is less information asymmetry which reduces the cost of equity and debt that is less used. As a result, there is a negative relationship between debt and tangible assets. Sung (2009) review relationship between financial leverage and investment opportunities for Chinese companies. This study used a measure of financial leverage ratio. Summary of Findings indicate that firms that have higher growth possess lower leverage ratios. The larger firms compare with smaller companies, are incurring more debt to invest. Noravesh and Yazdani (2010) examine the relationship between financial leverage and investments in listed companies in Tehran Stock Exchange. They study 98 companies in Tehran Stock Exchange for the years 2001 and 2006. The results suggest a negative relationship between financial leverage and investment, and this relationship for firms with fewer growth opportunities is stronger. Karimi et al (2009) review the effect of financial leverage and growth opportunities for the company's decision to invest in companies listed in Tehran Stock Exchange during the period 2001 to 2008. Franklin and Mitasamy (2011), in a study entitled "The effect of leverage on corporate investment decisions," conducted in which 25 pharmaceutical companies in India from 1998 to 2009. In this study, three different companies, large, medium and small corporations were divided into three experimental models (combined regression, fixed effect and random effect) were used simultaneously. The results showed that there is a positive relationship between financial leverage and investment. Also found that cash flow and retained earnings play a significant role in investment decisions.

4. Research hypothesis In sum, even if only because of the relationship between capital intensity with financial leverage, the power to take these assets as collateral since the use of fixed assets as collateral requires considerable amount of them and it can be expected that the relationship between capital intensity with financial leverage will not be linear. Therefore, the only research hypotheses are stated as follows:  Financial leverage has non-linear relationship with capital intensity.

5. Research Methodology This research is applicable based on the purpose of classification. Also, in terms of classification based on method is correlation. So regression model and regression tests were used.

164


6. Research Sample Firms listed in Tehran Stock Exchange form the research sample and selection is by elimination method based on the following criteria: 1) Financial Information be available for the research period, 2) be present in capital market during research, 3) their fiscal year ends in March 4) excluding investment firms and banks, leasing and insurance companies 5) do not change during the fiscal year, and 6) the book value of its equity isn’t negative. After excluding firms with lake of stated criteria, 111 firms is selected for years (2007 to 2012), we used audited financial statements, audit reports, Tadbirprdaz software and software system developed by the department, "manages the research, development and Islamic studies at the Stock Exchange", was obtained.

7. Research variables In this research, following regression is used to test the hypothesis: Leveragei,t = α + β1 Capital Intensityi,t + β2 Capital Intensityi,t2 + β3 Capital Intensityi,t3 + ԑi,t (1) Dependent variable: financial leverage (total debts to total assets ratio) Independent variable: capital intensity (fixed assets to total assets ratio).

8. Analyzing Research Findings Data of 111 companies during the years 2007 to 2012 were extracted from existing databases and inserted in Excel software. After performing the necessary calculations for the independent and dependent variables, the data required to test the proper file storage and software Eviews7 and SPSS17 processed. Before analyzing the survey data, the reliability parameters monitored. Reliability of variables has been tested. As a result, the use of these variables in the model is not to cause spurious regression. For this test, we used the results of Im, Pesaran and Shin which the result is optimal and P-value test for all variables is less than 0.05, and therefore, all variables in the period under review, are stable. The next test is used to test the multi co linearity. Multi co linearity condition indicates that an independent variable is a linear function of other independent variables. To calculate the index of multi co linearity tolerance and variance inflation factor is used. Tolerance is much lower (close to zero), the data variables are low and regression problems caused. The inverse of the variance inflation factor greater tolerance increases, causing increased variance of the regression coefficients. Desired value for the variance inflation factor is less than 10. It tolerance values and variance inflation factor is also quite good.

165


Dependent Variable: Leverage Method: Panel EGLS (Cross-section weights) Periods included: 5 Cross-sections included: 111 Total panel (unbalanced) observations: 555 Linear estimation after one-step weighting matrix Variable Coefficient Std. Error t-Statistic Constant 0.681112 0.016505 41.26767 Capital Intensity -0.644868 0.170933 -3.772625 Capital Intensity2 2.032150 0.535073 3.797890 Capital Intensity3 -1.363248 0.501316 -2.719337 Weighted Statistics 0.967727 R-squared Mean dependent var. 0.958114 Adjusted R-squared S.D. dependent var. 0.104188 S.E. of regression Sum squared resid. 100.6658 F-statistic Durbin-Watson stat 0.000000 Prob. (F-statistic) Table1. hypothesis Analysis

Prob. 0.0000 0.0002 0.0002 0.0068 1.399145 1.253869 4.081501 1.827776

With regard to the results presented in table 1, resulted equation is presented as follows: Leverage =0.681112 + )-0.644868*Capital Intensity( + )2.032150*Capital Intensity2) - (1.36348* Capital Intensity3( (2) Taking the derivative of the above equation with respect to Capital Intensity, the equation can be as follows: 0 = -0.644868 + 2*2.032150*Capital Intensity – 3*1.36348* Capital Intensity2 With another derivation we have:

(3)

0 = 2*2.032150 – 2*3*1.36348* Capital Intensity

(4)

→

Capital Intensity = 4.0643 / 8.18088 → Capital Intensity = 0.4968 Number three roots of the equation are:

(5)

∆=b2-4ac → ∆= (2*2.032150)2 – 4*(-3*1.36348)*(-0.644868) → ∆=5.9674 (6) Capital Intensity = (-4.0643±2.4428) / [2*(-4.09044)] → (7) Capital Intensity = 0.1982 & 0.7954 The maximum and minimum values are obtained, we can draw the graph. Also, simply by letting the sample data in the equations, we can estimate how it forms:

166


Figure 1: Approximate graph of relationship between capital intensity and financial leverage

9.Conclusion In this study we tried to review non-linear relationship between capital intensity and financial leverage of listed companies in Tehran Stock Exchange and according to the listed results in tables and figures we can conclude that if investing in fixed asset to total assets ratio be 0.7954, then leverage is in its maximum and total debt to total assets shows 77 percent and in amount higher than this we will face with reduction in leverage. In other words if this amount be 0.1982, leverage will be in its minimum and debt to asset ratio will be 62 percent.

References Anderson, G. (1990). “An empirical note on the independence of technology and financial structure”. The Canadian Journal of Economics, 23 (2), 693–699. Barton, S.L. (1988). Diversification strategy and systematic risk: another look. Academy of Management Journal, 31 (1), 166–175. Brealey, R. and Myers, S. (1984). Principles of Corporate Finance. McGraw-Hill, New York. Brigham, E. and Gapenski, L. (1996). Financial Management. Dallas: The Dryden Press. Ghadiri Moghadam, A., Shakeri, M. and Tavakolnia, E. (2013). Investigating the impact of human capital reporting (HCR) on financial performance, Stock Price and Firm Value. International Research Journal of Applied and Basic Sciences, 6, 2, 151-159. Hurdle, G. (1974). Leverage, risk, market structure, and profitability. Review of Economics and Statistics, 56 (4), 478–485. Karimi, F., Akhlaghi, H. and Rezaee Mehr, F. (2009). Reviewing influence of financial leverage on firms growth opportunity. Financial Accounting, 8, 60-74. Kimiyaghari, A.M. and Eynali, S. (2008). Presenting comprehensive method for financial structure. Accounting and Auditing Reviews, 42, 75-95. Long, M.S. and Malitz, I.B. (1983). Investment patterns and financial leverage. National Bureau of Economic Research (NBER), Working Paper Series. Lowe, J., Naughton, T. and Taylor, P. (1994). The impact of corporate strategy on the capital structure of Australian Companies. Managerial and Decision Economics, 15 (3), 245–257. Lubatkin, M. and Chatterjee, S. (1994). Extending modern portfolio theory into the Domain of corporate diversification: Does it apply?. Academy of Management Journal, 37, 109-136. Modigliani, F. and Miller, M.H. (1963). Corporate income taxes and the cost of capital. American Economic Review, 53, 433-443. Namazi, M. and Shirzad, J. (2004). Reviewing relationship between financial structure and firms profitability in listed firms Tehran Security Exchange. Accounting and Auditing Reviews, 42, 75-95. Noravesh, I. and Yazdani, S. (2010). Reviewing influence of financial leverage on investment on listed firms of Tehran Security Exchange. Financial Research, 4, 35-48.

167


Setayesh, M.H., Monfared, M. and Ebrahimi, F. (2011). Reviewing influence of effective factors on financial structure from agency theory. Accounting advances, 3 (1), 55-89. Shapiro, A.C. and Titman, S. (1986). An integrated approach to corporate risk management. In: Stern. J.M., Chew, D.H. (Eds.). The Revolution in Corporate Finance. Blackwell, Oxford, 215–229. Sheel, A. (1994). Determinants of capital structure choice and empirics on leverage behavior: a comparative analysis of hotel and manufacturing firms. Journal of Hospitality and Tourism Research, 17 (1), 3–16. Sung C. Bae., (2009). On the interactions of financing and investment decisions. Managerial Finance, 35 (8), 691- 699. Tang, C. H. and Jang, S. (2007). Revisit to the determinants of capital structure: a comparison between lodging firms and software firms. International Journal of Hospitality Management, 26 (1), 175– 187.

168