THE CAPITAL STRUCTURE ADJUSTMENTS OF FIRMS IN FIVE ASIAN ECONOMIES

ABSTRACT This paper provides a first attempt to analyze the long-run adjustment towards the target for Asian firms. Annual data from 1980 to 2003 of five Asian economies including Hong Kong, Japan, Singapore, Taiwan and Thailand are extracted from the PACAP database. Our sample includes 386 firms from Hong Kong, 1,722 firms from Japan, 158 firms from Singapore, 191 firms from Taiwan and 261 firms from Thailand. The partial adjustment models for book leverage and market leverage are estimated. Results show that the leverage ratios of Asian firms adjust gradually towards their target levels. Significant deviations from target due to the pecking order and market timing effects are found. In contrast to Kayhan and Titman (2007), we show that the market timing behavior does not persist. It is also found that Asian firms tend to use more debt than equity when external funding is needed. Keywords: Capital Structure; Pecking Order Theory; Market Timing Theory; Trade-OffTheory. 1. INTRODUCTION How firms arrive at their optimal capital structure is a question of debate. Three major hypotheses, namely, the pecking order hypothesis, trade-offhypothesis and market timing hypothesis, have been put forward in the literature to explain the optimal capital structure of a firm. The pecking order hypothesis (Donaldson, 1961; Myers, 1984) states that firms prefer internal financing by retained earnings to external financing and prefer debt to equity for external financing. Donaldson (1961) and Myers (1984) use the historical profit as a proxy of internal funds to test for the pecking order effect. If a firm prefers to use internal funds, the increase in the past earnings before interest and taxes (EBIT) tends to lower the debt ratio. Shyam-Sunder and Myers (1999), Frank and Goyal (2003) and Brounen et al. (2006) present evidence of firms' pecking order behavior. The trade-offhypothesis implies that firms make the capital structure decision based on the cost and benefit of different sources of financing. An optimal (target) leverage ratio is achieved when the marginal cost and marginal benefit of using extra debt and equity are equal. Baker and Wurgler (2002) propose the market timing hypothesis that firms prefer to issue equity when the market overvalues the equity relative to the book value and to repurchase equity when the shares are undervalued.1 The hypothesis implies that a high market-to-book ratio tends to lower the debt ratio as it indicates overvaluation of the shares. Recently, the partial adjustment model has been widely applied to explain the change of debt ratio. Korajczyk and Levy (2003) use macroeconomic factors to analyze the 3-year change of leverage. Kayhan and Titman (2007) study the adjustment of the capital structure of US firms and show how the firms' histories of cash flows, investment expenditures and stock performance affect the change in capital structure in the long run. In this paper, we examine the capital structure of Asian firms, with a focus on its long-term adjustment towards the target. While some previous works have examined the determination of capital structure of Asian firms (Deesomsak et al., 2004), studies on its adjustment process are scant. This paper estimates the long-run adjustment of the capital structure of firms in five Asian economies. The sample covers the industrial firms from Hong Kong, Japan, Singapore, Taiwan and Thailand. The contribution of this paper is two-fold: (1) It is the first study on the long-run adjustment towards the target for Asian firms; (2) It also analyzes the persistence and reversal effects. Our model contains tradeoff, pecking order and market timing variables to test for the corresponding hypothesis. The rest of this paper is organized as follows: Section 2 describes the data. In Section 3, the target debt ratios of firms in the five Asian economies are estimated by tradeoffvariables using the method of Deesomsak et al. …