Investigation of Target Capital Structure for Electronic Listed Firms in Taiwan

This paper investigates the existence of an optimal debt ratio for the electronic listed firms in Taiwan, using balanced panel data for a sample of 143 selected electronics companies listed in the Taiwan Stock Exchange (TSE) from the first quarter of 1999 to the third quarter of 2004. The result shows that there is a single threshold effect of debt ratio on firm value when return on equity (ROE) is used to proxy firm value. Furthermore, based on our combined findings of ROE and earnings per share (EPS) triple threshold estimations, we find that the appropriate debt ratio range for the electronic listed firms in Taiwan should not be over 51.57 percent or below 12.37 percent. To ensure and enhance the firm’s value, the optimal range of debt ratio should be within 12.37 percent and 28.70 percent. The implications of the findings for financial managers and shareholders’ welfare are discussed. KEy words: capital structure, debt-to-assets ratio, firm value, panel threshold effect. A financial manager in a corporation is responsible for establishing financial policy and planning to maximize firm value and stockholders’ welfare. One important element is deciding how much leverage should be applied. Generally, a higher debt ratio can enhance the rate of return on equity capital. However, a higher debt ratio also increases the risk of the firm’s earning. Therefore, a capital structure decision involves trade-offs between risk and capital return. This paper aims to find an optimal debt ratio (debt to total assets, D/TA) for the capital investment and investigating effects of financial leverage on a firm’s performance or firm value for the electronic listed firms in Taiwan. In the past several decades, the effect of a firm’s capital structure on policy has been important in the field of corporate finance. Modigliani and Miller (1958; 1963) first discussed the relation between firm value and capital structure. Traditionally, there have been two main conflicting theories. The trade-off theory mainly describes the benefit and cost of debt, such as the benefit of tax deductibility of interest (Modigliani and Miller 1963), agency costs of debt and equity (Harris and Raviv 1990; Jensen 1986; Jensen and Meckling 1976; Myers 1977; Stulz 1990), and asymmetric information (Leland and Pyle 1977; Ross 1977). The pecking-order theory (Chirinko and Singha 2000; Frank and Goyal 2003; Myers 1984; Myers and Majluf 1984; Shyam-Sunder and Myers 1999) states that managers do not pursue a particular capital structure due to the presence of asymmetric information between better-informed managers and less-informed investors. Therefore, Chien-Chung Nieh ([email protected]) is professor, chairman, and director of the Department of Banking and Finance, Tamkang University, Tamsui, Taipei, Taiwan. Hwey-Yun Yau ([email protected]) (corresponding author) is a lecturer in the Department of Accounting and Information, National Taipei College of Business, Taiwan. Wen-Chien Liu (95357503@nccu. edu.tw) is a Ph.D. candidate in the Department of Finance, National Chengchi University, Taiwan. The authors thank Ali M. Kutan and a referee for their valuable comments and suggestions, which have greatly enhanced the quality of this paper. D ow nl oa de d by [ T am ka ng U ni ve rs ity ] at 1 9: 44 1 9 Ju ne 2 01 6 76 Emerging Markets Finance & Trade firms gather capital first through internally retained earning, then through low-risk debt. Equity is the last resort, under duress. Recently, in addition to the traditional trade-off and pecking-order theory mentioned above, there have been some newly developed points of view about the decisions of capital structure. Baker and Wurgler (2002) illustrate the effect of equity issuance timing on capital structure. Other examples that also refer to the patterns of market timing theory include Alti (2006), Graham et al. (1999), Hovakimian (2006), Huang and Ritter (2007), Jenter (2005), Kim and Wu (1988), and Kisgen (2006). In addition, Welch (2004) finds that equity price shocks have a long-lasting effect on corporate capital structures and stock returns are the primary determinant of capital structure changes. Both of these two points of view are inconsistent with the trade-off theory, which pursues a particular optimal capital structure. However, other studies provide direct evidence that firms indeed have optimal capital structures and adjust toward them—consistent with trade-off theory (Fama and French 2002; Flannery and Rangan 2006; Jalilvand and Harris 1984; Marsh 1982; Taggart 1977). Taiwan, a typical island and export-oriented country, is one of the major suppliers of electronics and information technology (IT) products to the United States and the rest of the world. Taiwan’s economy now relies more on capital-intensive goods than ever. Whiting (1991) has pointed out that its weighted average debt as a percentage of total capital within the electronics industry is higher than within other types of industry.1 Therefore, it is worth exploring the effect of financial leverage on firm value for listed electronic companies in Taiwan. This paper applies a threshold regression model to the observed balanced panel data to study the effect of the D/TA ratio on firm value, the threshold effect, and any asymmetrical response, if it exists. This paper contributes to the previous literature in four aspects. First, we apply the advanced panel threshold regression model developed by Hansen (1999) to test if there exists a threshold of optimal debt usage. In contrast to the traditional linear model, this nonlinear threshold model can describe the trade-off between the benefits of tax shelters that come from more debt and the disadvantages of costs from additional debts that may negatively affect corporate performance or value. Second, we closely examine the financial characteristics of the electronic listed companies to solve the short period sample problems. Third, we use both accounting measurements of ROE and EPS to proxy firm value. Finally, two related control variables are considered and added to the regression analysis to make our nonlinear model more realistic. Methodological Issues Hansen’s (1999) panel threshold regression model is an extension of the traditional leastsquared estimation method. It requires that the variables in the model be stationary to avoid a “spurious regression.”2 We thus employ a unit-root test in our first step. Because the data sets are all panels in our investigation, both well-known LLC (Levin et al. 2002) and IPS (Im et al. 2003) techniques are employed for our panel unit-root tests.3 Assuming that the optimal debt proportion appears to be relevant to corporate performance or the value of listed electronic firms in Taiwan, this paper aims to find if there is a threshold effect and tries to use a threshold regression model to estimate the ratio appropriately. This may capture the relation between financial leverage and firm value as well as help financial managers make decisions. As a second step, we introduce the procedure briefly, as follows.4 D ow nl oa de d by [ T am ka ng U ni ve rs ity ] at 1 9: 44 1 9 Ju ne 2 01 6