The Influence of Capital Structure on the Value of Public Companies in Chemical Industry

The study is about the influence of the financial leverage and its square term on the value of a firm in chemical industry in different parts of the world. The maximizing of the value of a firm is considered to be one of the main goals of business activity of any company. Thus, the management needs to choose different strategies including financing one that raise firm’s value. For that the relationship between firm’s value and its financial leverage needs to be known as specifically as possible. In the study these specifications include country and industry differences. The panel data analysis of public chemical companies in five parts of the world is used to reveal the types and signs of this influence. It is shown that the financial leverage and its square term have opposite influence on the value of a firm for the whole sample as well as the companies in different parts of the world. This means that small and big amounts of debt have different effect on firm’s value. The influence is not the same in different parts of the world. The companies in Europe, Asia and Africa would better follow the pecking order theory of financing and the companies in North and South America – the trade-off theory for choosing best financing strategies in order to maximize the value of firms.


INTRODUCTION
One of the most important indicators for any firm is its value. Raising it is considered one of the most important goals of business. So it is important to know and manage factors affecting it, especially the financial leverage. The known relationship between firm's value and financial leverage can show and help companies' managers the optimal financing strategy that will raise the value of the company in the eyes of potential investors.
There have been a whole bunch of different researches devoted to this topic since the introduction of it by Modigliani and Miller (1958). However, they never came to a universal conclusion about this influence of the financial leverage on the value of a firm. Many of them tried to introduce factors that help to clarify the differences in this influence. In this work three such important factors are introduced. First of all, a specific industrychemicalis chosen to avoid industry specific effect. Secondly, a geographical division of companies is used. Thirdly, a new factorthe square term of financial leverageis used in the analysis.
The goal of this work is to detect the influence of capital structure on the value of public companies in chemical industry.
In the first part of the work the existing works on the relationship between of the financial leverage and the value of a firm will be considered. The second part will be devoted to hypotheses and methodology of the study. The third part will include the description of data and results of econometric analysis.

LITERATURE REVIEW
The aim of this literature review is to examine the existing body of academic articles about the influence of firm's capital structure on its value. However, firstly, we will look at the reasons that influence the choice of the capital structure itself starting with the earlier fundamental works on the subject. Then we'll consider the two financing theories. Secondly, we'll review the works about the actual relationship between the chosen financial leverage and firm's value and the factors that might influence it. Thirdly, we'll briefly consider the most popular way to measure company's value.
A work of Modigliani and Miller (1958) can be regarded as the fundamental work in the area of investing and particularly financing decisions of a company. They argued that the introduction of certain assumptions (effective capital market, the absence of taxes, asymmetric information, agency costs and the costs of bankruptcy), ensure that investment and financing decisions are made separately from each other. However, in a real market these assumptions often are not met, so after the work of Modigliani and Miller the studies followed, removing one or more of the assumptions given above.
One part of these works are associated with the presence of taxes (and accordingly with the existence of tax shields), and the presence of bankruptcy costs. Thus, DeAndzhelo and Masulis (1980) removing the assumption about the absence of taxes created a model in which there is an inverse relationship between financial leverage and substitutes for the tax shield related to debt (mainly these are tax shields related to depreciation, that is to the result of realization of investment projects). Their work was extended by Dammon and Senbet (1988) who added investment as an important endogenous parameter. They showed that the increase of tax shields, which are related to investments, do not necessarily lead to the reduction in debt levels.
The future research continued to use the idea of tax shields as an important parameter for making financial decisions. However, they started to be explained also by information asymmetry on financial market. Using these factors (basically taking away some of Modigliani and Miller assumptions) two theories explaining the choice of capital structure by a firm were developed: the trade-off theory and the pecking order theory.
The pecking order theory rejects the assumption of the absence of information asymmetry and transaction costs. Myers and Majluf (1984) show that companies prefer the internal financing to the external financing using their reserves and retained earnings. When using the external financing companies prefer to issue debt, rather than to issue shares. This is due to the fact that when there is information asymmetry the stock price falls with the release of new equity and remains at the same level with the debt issue. And in addition, the operating costs of the issue of shares are higher than the issue of new debt and internal financing. This approach is the basis for many works that clarify and add to it. One of the testing methods of how much companies follow the pecking order theory, is to study the dependence of changes in debt on the company's deficit. (Shyam-Sunder, Myers, 1999;Frank,Goyal, 2003;Ivashkovskaya,Solntseva, 2008). This dependency ratio should be close to one if the company uses the pecking order theory. Shyam-Sunder and Myers explain the ratio's possible deviations from this value with the existence of transaction costs that prevent firms' optimal response.
The trade-off theory, in its turn, gets rid of the assumption of the absence of taxes and bankruptcy costs. Kraus and Litzenberger (1973) show that companies are looking for the optimal amount of debt, focusing on the amount of taxes and costs of non-payment of debt.The tax rate is significant, if the interest payments on the debt are not taxed. In this case, the growth of debt volume in the capital structure reduces taxable income and thus increases the profit remaining after tax. However, since the debt is to be paid in full and in a certain period, in the absence of the necessary means to carry out payments the company may be threatened by bankruptcy, which will lead to a decrease of the company value (if the firm is able to continue its activities) or to bear large costs associated with the closure of the company. Accordingly, firms choose a level of debt that would be balanced by the gain of the tax shield and loss from bankruptcy costs, that is the level which maximizes firm value.
This approach also was used in a number of subsequent studies. One way to check the companies' following of trade-off theory is the study of changes in debt levels based on its deviation from the optimal value (Shyam-Sunder, Myers, 1999;Fama, French, 2002;Ivashkovskaya,Solntseva, 2008). In this case, the dependency ratio should be close to one, that is, the firm should seek to adjust their debt for as much as it differs from optimal.
Some studies based on company surveys also confirm the existence of exact or floating target debt level (Graham and Harvey, 2001).
A company may follow different strategies to choose its capital structure as this financial decision is rather important: it can influence different aspects of the business such as company's performance, risk of bankruptcy, profits and most importantly its market value.
The whole body of previous research exists on the question of influence that financial leverage has on value of firms. However, there isn't a single opinion about the sign of this relationship or factors vital to defining it. In table 1 there is the overview of different studies of this question.  The authors also tried to find any difference in the specified relationship for companies with different growth rates and levels of financial leverage. However, it was revealed that companies with both high and low growth had the similar correlations between financial leverage and firm's value. And just the same companies with both high and low financial leverages had no statistically significant differences in the studied relationships.
Another group of researchers (Fosu et al., 2016) also found that the relationship between financial leverage and firm's value was negative for UK public firms. Like Soumadi and Hayajneh these authors studied whether a factorinformation asymmetryhad an effect on this relationship. They discovered that the more firms had information asymmetry the less firm's value was affected by financial leverage.Cai and Zhang (2011) studied companies in the USA. They detected that increase in the financial leverage negatively affected stock prices of the firm. Besides this effect was increased if firms had a problem of debt overhang.
Yet not all works revealed the presence of relationship between financial leverage and firm's value. Ishari and Abeyrathna (2016) using the sample of Shri-Lanka companies showed that the relationship was weak (even though it was negative). At the same time Barakat (2014) found no correlation between financial leverage and firm's value at all for the Saudi Arabia firms.
In another article (Fosu, 2013) based on research of South African firms the impact of financial leverage on firm's performance (measured by return on assets) was studied. It was revealed to be positive and dependent on product market competition which enhances the impact. Weil (2008) also studied relationship between financial leverage and firm's performance, but in European countries. He found that the relationship in Germany, France, Belgium, Norway and Spain is positive, in Italy it is negatives while in Portugal there is no such relationship. This proves that even using one methodology and studying firms in one time period the correlation between the financial leverage and the firm's value is different.
Unfortunately, the authors didn't research the relationship between financial leverage and the actual value of the firm.
In order to study the impact that financial leverage has on firm's value almost all works mentioned above used Tobin's q as a measure of latter variable. The most common method to approximate Tobin's q was given in the model of Chung and Pruitt (1994). According to them it can be measured as firm's market value of equity and book value of debt divided by book value of its assets.
As existing literature reveals that the financial leverage can be chosen by the firms according to different strategies (for example, balancing between tax advantages and bankruptcy disadvantages of debt or measuring the information asymmetry between managers and potential investors). But however chosen, the leverage influences such important indicator as firm's value. Even though most researchers agree that this influence exists in real world they can't come to a single opinion as to what exactly (positive or negative) is the relationship between the financial leverage and the firm's value.
It is worth mentioning that some researchers tried to find factors that cause the relationship to be different for different firms. Yet in most cases the sign of relationship stays the same even if it becomes stronger or weaker when companies answer a certain condition about the studied factor. Also we can see that there are cases when different studies of firms of one country but different industries produced opposite results. This indicates that industry might have a significant influence on the impact of financial leverage on firm's value. The similar conclusion can be reached about countries: the same methodology applied to different countries produced different results. Furthermore, some studies showed that though financial leverage of a firm continuously grew or fell, its value could first increase and then decrease or vice versa.

HYPOTHESES
First of all, it needs to be mentioned that only firms in chemical industry will be studied in this research. Financial performances of firms differ across different industries. The researchers found that there is a distinctive variation in capital structure across the industries Based on the literature research above four hypotheses can be developed.

H1. In chemical industry the financial leverage influences the firm's value.
According to most of studies in the literature review financial leverage has either positive or negative influence on the firm's value. This holds true not only for the firms of a specific country but also to the firms of a specific industry (Khan, 2012; Farooq and Masood, 2016).
Positive influence can be explained by tax advantages (Modigliani and Miller, 1963). Tax shields from using debt allow firms to save money for future investment or dividends rising firm value. Also positive influence can be a result of the discipline of managers provided by debt: it helps with overinvestment problem resulting from empire building by managers (Jensen, 1986;Stulz, 1990). In firms that use more debt managers are more likely to act inthe shareholders' interests. Furthermore, positive influence of leverage on value might be explained by banks' control over their loans: in some cases they give financing only for investment in healthy profitable projects (Soumadi, Hayajneh, 2012).
On the other hand, negative influence can be a consequence of a debt overhang problem (Myers, 1977). Too much debt discourages firms from taking investment projects as most of the profit from them will go to creditors anyway. This results in the decreasing of the firm value. Also big amounts of debt increase the cost of borrowing for firms decreasing their profitability and as a consequencefirm value (Abor, 2005). The trade-off financing theory also implies the existence of an optimal leverage value (Kraus, Litzenberger, 1973). This means that the value of company will rise as the leverage rises to that optimum value and will fall as the leverage continues to rise past the optimum.

H2. In chemical industry in different countries
Where MVEq is the total market value of equity of a company, TotLiab is the total amount of liabilities of a company and TotAs is the total amount of assets of a company in a year.

Independent variables
The two main dependent variables are the financial leverage of a company (FinLev) and the square term of the financial leverage of a company (SqFinLev). The financial leverage iscalculated as the proportion of debt (both long term debt and short term current liabilities) to a company's total assets in a year: WhereLTDebt is the total amount of long term debt of a company in a year, CL is the total amount of current liabilities of a company in a year and TotAs is the total amount of assets of a company in a year.
The square term of the financial leverage is calculated as:

Control variables
Control variable for size (Size) is measured as a natural logarithm of total assets of a company: Where TotAs is the total amount of assets of a company in a year.
To control for the influence of value-generating intangible assets variable tangibility (Tang)is introduced. It is calculated as a ratio of fixed assets to total assets of a company: Where FixAs is the total amount of fixed assets of a company in a year and TotAs is the total amount of assets of a company in a year.
As a control for growth opportunities growth of sales variable (SalesGr) is added to the models. It is measured as a division of sales of a current year by sales of a previous year: Where Sales t is the total amount of sales of a company in a year and Sales t-1 is the total amount of sales of a company in a previous year.

Models specification
To test the first hypothesis that the financial leverage influences the value of a firm we use the following panel regression (7): Here we don't introduce country effects so the coefficient β 1 shows the influence of the leverage on the value for firms all over the world.
To test the second hypothesis that the same panel regression (7) is used. However, we run several regressions (each for one country) and compare coefficients β 1 . It shows whether in different parts of the world the influences of the financial leverage on the firm's value have different signs.
For the testing of the third hypothesis that the square term of the financial leverage influences the firm's value we add the variable for the square of the financial leverage and estimate the following panel regression (8): Here again no country differences are accounted for and only the general relationship between the square tern of the financial leverage and the value of a firm is studied. It is shown by the coefficient β 2 .
To test the fourth hypothesis that the relationship mentioned above is different in different countries the panel regression (8) is used again but it is run for each parts of the worldindividually and coefficients β 2 are compared.

DATA
The sample used for the research contains public companies from chemical industry financial information for which were taken from 1998 till 2016 depending on its availability.     According to the tests random effects regression model was chosen as the most suitable. On the whole the regression is significant. Both the financial leverage and two control variables (size and tangibility) have significant effect on Tobin's Q in the sample of chemical public companies all over the world. The market value of a company depends positively on its financial leverage. Thus, it is possible to say that the more debt the company has the more the bigger economy on tax it gets as well as the more discipline for top managers so bigger amounts of debt rise the value of a firm.Also size and tangibility have a positive influence on value of a firm which makes sense as bigger firms with more physical assets are likely to have bigger value. Thus, first hypothesis is not rejected.
The regression results for testing of second hypothesis can be seen in table 6 below.
According to the tests different types of regression models were chosen as the most suitable for different parts of the world (Asiapooled model, North America, South America, Africa fixed effects model, Europerandom effects model). According to the tests fixed effects regression model was chosen as the most suitable. On the whole the regression is statistically significant. All independent variables apart from sales growth have significant influence on the Tobin's Q. Same as in the regression of first hypothesis testing firm's market value depends positively on the financial leverage. At the same time the square term of financial leverage influences market value negatively.
Together these two facts mean that market value rises with the growth of debt up to some point and then begins to fall at higher levels of debt. This means that for public chemical firms there exists some optimal amount of debt so it might make sense for them to follow trade-off theory of financing. Size and tangibility have a positive influence on firm's value as in the previous hypotheses. Thus, third hypothesis is not rejected.
The regression results for testing of fourth hypothesis can be seen in table 8 below.
According to the tests different types of regression models were chosen as the most suitable for different parts of the world (Europe, Asia, North Americafixed effects model, Africarandom effects model).  Thus, fourth hypothesis is not rejected.

FURTHER DIRECTIONS OF RESEARCH
Further directions of research may be connected with the influence of different factors such as company's growth opportunities, its financial health, information asymmetry between managers, investors and creditors, likelihood of a debt overhang effect the relationship between financial leverage and firm's value. Also the period studied might be splitted into two parts: prior and after the financial crisis of 2008 as it might have caused changes in companies' policies.

CONCLUSION
Rising value of the firm is one of the most important goals for the business so it is necessary to know, monitor and manage factors affecting it, especially the financial leverage.
Previous studies have shown that relationship between financial leverage and firm's value exists. However, they did not come to a universal conclusion about the sign of such relationship.
The research done in this work has shown that this relationship is different for companies in different parts of the world. More than that, it might change depending on whether only financial leverage is included into the relationship or its square term as well. For example, for Europe the influence of financial leverage on the value of a firm seems to be positive.
However, the more detailed analysis shows that it is the square term of financial leverage which influence is positive while the influence of financial leverage itself is negative.