Cross-Country Determinants of Capital Structure Choice: A Survey of European Firms

Franck Bancel (ESCP-EAP)

Usha R. Mittoo (University of Manitoba)

Forthcoming in Financial Management Journal

Abstract We survey managers in 16 European countries on the determinants of capital structure. Financial flexibility and earnings per share dilution are primary concerns of managers in issuing debt and common stock, respectively. Managers also value hedging considerations and use “windows of opportunity” when raising capital. We find that although a country’s legal environment is an important determinant of debt policy, it plays a minimal role in common stock policy. We find that firms’ financing policies are influenced by both their institutional environment and their international operations. Firms determine their optimal capital structures by trading off costs and benefits of financing. Keywords: Capital Structure, European Managers, Survey, Debt, Equity JEL Classification: G32, G15, F23. We are grateful to all chief financial officers who have participated in this study, and to John Graham, two anonymous reviewers, and corporate finance teams of BNP Paribas and Merrill Lynch for their valuable comments and suggestions on an earlier version of our paper. We also thank Lawrence Booth, Amitabh Dutta, and participants at the 2002 European Financial Management Association meetings, the 2002 Multinational Financial Society meetings, the 2002 Northern Finance Association meetings, the 2002 CGA Conference (University of Manitoba), and the 2003 American Finance Association meetings for helpful comments, and Zhou Zhang for research assistance. Mittoo acknowledges financial support from the Bank of Montreal Professorship. Corresponding authors: Franck Bancel Professor ESCP-EAP 79 avenue de la République 75 543 Paris cédex 11 - France Phone: (33) 1 49232076, Fax: (33) 1 49232036, Email: bancel@escp-eap.net

Usha R. Mittoo Bank of Montreal Professor in Finance I.H. Asper School of Business University of Manitoba Winnipeg, Manitoba, R3T 5V4 - Canada Phone: (204) 474-8969, Fax: (204) 474-7545, Email: umittoo@ms.umanitoba.ca

Cross-Country Determinants of Capital Structure Choice: A Survey of European Firms

How firms make their capital structure decisions has been one of the most

extensively researched areas in corporate finance, yet there is little consensus among these studies. In a recent paper, Graham and Harvey (2001) examine the theory and practice of corporate finance by surveying U.S. managers. Our study does the same in the European context, but differs in its scope and focus. Unlike Graham and Harvey who examine several aspects of corporate finance in a single country, we focus on the cross-country comparisons of managerial views on determinants of capital structure in a sample of 16 European countries: Austria, Belgium, Greece, Denmark, Finland, Ireland, Italy, France, Germany, Netherlands, Norway, Portugal, Spain, Switzerland, Sweden, and the U.K.

Our study examines whether European and U.S. managers’ views on capital structure are driven by similar factors. We also examine the role of legal institutions in explaining the financing policies of firms across countries. We investigate whether these policies are determined largely by the legal institutions of the home country or are the result of a complex interaction of several institutions in a country. We also study the sensitivity of different determinants of capital structure to the country’s institutional environment. It is possible that factors underlying debt or equity policies may be influenced differently by various institutions. Thus, to understand the impact of a country’s institutions on leverage, we need to analyze determinants of different components of leverage across countries, which is an onerous task. We examine this issue by asking managers about the determinants of the debt, equity, convertible, and foreign capital-raising policies of their firms.

The paper is organized as follows. In Section I we develop our hypotheses and describe our method. Section II compares European managers’ views with those of U.S. managers. Section III presents our cross-country analysis. Section IV summarizes and concludes.

I. Hypotheses and Survey Design We first develop the hypothesis on the literature and then discuss our sample and data. A. Hypotheses

Graham and Harvey (2001) test the implications of different capital structure theories through a survey of U.S. managers. They find moderate support that firms follow the trade-off theory and target their debt ratios. They also find some support for the pecking-order theory. Their results show that firms value financial flexibility

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but its importance is not related to information asymmetry or growth options in the manner predicted by the pecking-order theory. They find little evidence that other factors including agency costs, signaling, asset substitution, free cash flow and product market concerns affect capital structure choice. They also report that managers use many informal criteria, such as credit rating and earnings per share dilution, in making their financing decisions. An important issue is whether U.S. managers’ views are influenced largely by the U.S. institutional environment or are also shared by their peers in other countries. We examine the following hypothesis:

H1: European and U.S. managers make their capital structure decisions using similar factors, all else equal.

Several studies have examined the role of different institutions in explaining

differences in leverage across countries. La Porta, Lopez-de-Silanes, Shleifer, and Vishny (1997, 1998) stress that the legal system is the primary determinant of the availability of external financing in a country. They argue that common-law system provides better quality of investor protection than civil-law systems, and among the civil-law systems, German and Scandinavian systems provide better protection than French system. They show that the size and breadth of capital markets vary systematically and positively with the quality of legal systems across countries. Demirgüç–Kunt and Maksimovic (2002), however, argue that a country can partially compensate for the effect of the deficiency of the legal systems on banks through a combination of administration and regulation of the banking system, and that the legal systems in different countries can have different comparative advantages in supporting a quality banking system or quality securities markets. Demirgüç–Kunt and Maksimovic (1999) show that debt maturity is affected by both financial and legal institutions in their study of debt policies across 30 countries. Rajan and Zingales (2003) examine the evolution of European financial system over time and conclude that it reflects a complex interaction of several country and global factors including economic and political.

Rajan and Zingales (1995) compare leverage and its determinants across G-7 countries and find that although leverage and its correlations with variables, such as firm size and profitability, are fairly similar across their sample countries, the theoretical underpinnings of the observed correlations are different. Booth, Aivazian, Demirgüç–Kunt A. and Maksimovic (2001) find that although the capital structure decisions in their sample of ten developing countries are affected by the same variables as in the developed countries, there are persistent differences across countries. Other studies show that the increased accessibility to global capital markets, through firms’ foreign listing or multinational operations, also influences capital structure (see for e.g., Pagano, Röell, and Zechner (2002), and Doukas and Pantzalis (2003)).

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The evidence on whether financing policies of firms are determined primarily by the legal system of its home country or whether other country institutions also play a major role is unclear. A major problem in the cross-country research is that differences in accounting and disclosure practices make it difficult to compare and interpret financial data across countries. Further, different components of leverage, such as debt or equity, are likely to be influenced differently by various institutions. For instance, debt financing is likely to be more sensitive to the bankruptcy law, but equity financing might be influenced more by the stock market regulation in a country. Moreover, it is almost impossible to collect data on the evolution of the financial system in a country over time. To the extent a country’s institutions affect its financing structure, their impact should be reflected in managerial policies and practices in that country.

We examine the following hypotheses on the sensitivity of the important determinants of debt and equity, as identified by managers in our survey, to legal systems:

H2: Cross-country differences in managerial views on the determinants of capital structure are influenced primarily by the legal system of the home country, all else equal.

H3: Cross-sectional differences in managerial rankings of major determinants of debt and equity policies differ systematically according to the quality of legal systems, all else equal. B. Survey

The design of our questionnaire is similar to that in the Graham and Harvey (2001) study, but we add or modify several questions to facilitate cross-country analysis. For example, we ask managers questions on the ownership structure, the influence of different stakeholders on their firm’s financial decisions and foreign sales, foreign listings, and foreign capital-raising activities. We had academics and financial executives test the first draft of the survey questionnaire in summer 2001 and revised it after incorporating their suggestions. Our final questionnaire is structured around nine topics and comprises about 100 questions. 1. Sample We select our sample of firms to maximize representation and to minimize firm-specific differences across European countries. We construct our initial sample from two sources. First, we include all non-French European firms for which the French Financial Journal La Tribune provides daily trading information. These firms represent different industries and most of them are either part of the national stock index of their country or of other market indexes such as European Nasdaq. We obtain a total of 621 firms from this source. We add another 116 French firms that

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comprise the SBF 120 index. We delete 17 firms because of non-availability of their addresses. Our final mailing group totals 720 firms.

The data characteristics of our initial mailing group are for the year ending December 2001. We mailed the survey to the chief financial officers (CFOs) of all sample firms.1 We kept the survey anonymous to facilitate honest responses. We made three mailings. The first mailing was done in September 2001, the second in November 2001, and the third in January 2002. We included a letter with each mailing that explained the objectives of the study and promised to send a summary of our findings to those who wished to receive it. We received 87 responses by mail or by fax, representing a 12% response rate. Insert Table I

Table I compares the percentage of responses across countries and across English, French, German, and Scandinavian law countries. The largest number of sample firms (about 45 %) belong to the French law countries followed by the English (21 %), German (19 %), and Scandinavian (15 %) legal systems. France, Germany, and the U.K. have the largest number of respondents. This response rate is not surprising, because these countries also represent about half of the initial mailing group.

The univariate and multinomial tests in Table I show that the proportions of our respondents across countries and legal systems are similar to those in our initial mailing group. We also find that the mean (median) market capitalization and P/E ratios of respondents, and the proportion of dividend paying respondents, are similar to those in the initial mailing group across all legal systems (not reported for brevity). Thus, nonresponse bias does not appear to be a major problem in our survey. 2. Summary Statistics of Respondent Firms

Figure I presents the characteristics of respondent firms. Most of the respondent firms are large; over 75 % have sales and market capitalization over €1 billion. These firms represent several industries, and are concentrated in the manufacturing, mining, energy, and transportation (about 37 %), high technology (18 %), and financial sectors (18 %). High-growth firms, which we define as firms with P/E ratio greater than 14, comprise 65 % of the sample. 66 % of the firms are also widely held public firms, and 36 % have multiple classes of shares. Over 90 % are non-utility firms and pay regular dividends. Insert Figure I 1 We obtained the names and addresses of the CFOs from the Bloomberg database provided by BNP Paribas. We mailed the survey to the chief executive officer (CEO) if the name of the CFO was not available. A copy of the survey instrument is available on: http://www.escp-eap.net/faculty_research/publications/Publications/fbancel/mdq6.pdf

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About 75 % of the firms have a target debt-to-equity ratio. The estimated cost of equity for most firms ranges between 9 % and 15 %, and over 60 % of the sample firms use the capital asset pricing model (CAPM) to calculate this cost. The average long-term debt to total debt ratio is 66 %, but it varies from a minimum of 4 % to a maximum of 96 %. The average (median) debt ratio (total debt to market value of equity) is 113 % (35 %) and the average (median) long-term debt ratio is 44 % (24 %). Most of the respondents report that the financial policy of their firm is influenced primarily by their stockholders and to a far lesser degree by other stakeholders.

Most of our respondents are also internationally oriented. 58 % have the majority of their sales in foreign countries, and have raised foreign capital during the last ten years. 45 % of the respondents are also cross-listed on foreign exchanges, and 16 % are listed on both European and U.S. stock exchanges.

We also collect information on characteristics of the CEOs of the firms. The majority of the managers (87 %) own less than 5 % of their firm’s stock (Figure 1-M), 58 % are between 50 and 59 years old, and 68 % have a Masters degree (40 % have an MBA) (untabulated).

Table II presents the correlations among the demographics of the respondent firms. Panel A shows the variables used in previous studies on capital structure. The variables in Panel B are more relevant for analyzing the cross-country differences. The correlations among the variables are largely as predicted in the literature. For example, high P/E ratio firms are likely to have a lower D/E ratio, higher managerial stock ownership, a higher percentage of free-float shares, and a lower estimated cost of equity. However, the average strength of correlations among these variables is much lower than that in the Graham and Harvey (2001) study. This finding could reflect the differences in the demographic variables of firms in the two samples. For example, over 90 % of our sample firms pay regular dividends compared to less than 55 % in the Graham and Harvey study. These differences are likely to be more pronounced across different countries. Insert Table II II. Comparison of European and U.S. Managers’ Views

Tables III through VI present the European and U.S. managers’ responses on debt, equity, convertible debt, and foreign capital-raising policies. . We ask managers to rank the importance of different factors on a scale of zero to four (with zero as not important and four as very important). A. European Views

We summarize European managers’ views on their capital structure decisions and discuss their implications.

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1. Debt Policy We ask European managers three questions on the debt policy of firms. Table III (Panel A) summarizes the responses on how firms choose the appropriate amount of debt. Executives cite financial flexibility as the most important factor (mean rank 3.39), followed closely by credit rating (mean rank 2.78).2

Firm managers also care about the tax deductibility of interest (mean rank 2.59), volatility of earnings (mean rank 2.33), concerns of customers/suppliers about firm’s financial stability (mean rank 1.97), and the potential costs of bankruptcy (mean rank 1.76). These concerns are consistent with the trade-off theory. Managers consider the transaction costs of debt and debt levels of industry peers as less important.

Table III (Panel B) presents the managerial rankings of other factors that influence the debt policy. A majority of managers (70 %) try to minimize the weighted average cost of capital (mean rank 2.8). Over 40 % of managers issue debt when interest rates are low (mean rank 2.1) or when the firm’s equity is undervalued by the market (mean rank 2.08). These findings suggest that managers use windows of opportunity to raise capital. Insert Table III

Table III (Panel C) summarizes the responses on factors that drive a firm’s choice between short- and long-term debt. To decide the maturity of debt most managers (77 %) use the matching principle, matching the maturity of debt with that of the assets financed (mean rank 3.1). 70 % of respondents also state that they issue long-term debt to minimize the risk of refinancing in bad times (mean rank 2.83) and about one third report that they issue short-term debt when they are waiting for the long-term interest rates to decline (mean rank 1.85). 2. Common Stock Policy

Table IV presents managers’ views on the determinants of their firm’s common stock policy. Over 77 % of the respondent firms have issued equity during the last ten years. A majority of the managers rank earnings per share dilution as the most important factor in their equity issuance decision (mean rank 2.72). Fifty-nine percent of managers (mean rank 2.67) also rank maintaining a target debt-to-equity ratio as important. This finding is consistent with the trade-off theory. Managers also appear to be actively involved in selecting the timing of equity issues. 59 % of managers report that issuing stock after a rise in the firm’s stock price is an important factor (mean rank 2.61), and about 50 % also agree that the amount of stock over- or undervaluation is important in issuing equity (mean rank 2.44). 2 Executives we met to present our results explained us that it is really important to "negotiate financing when you don't need it".

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Insert Table IV

Many respondent firms issue common stock for employee stock option plans (mean rank 2.07). Managers also tend to issue equity when there are insufficient profits to finance investment activities and not when they are unable to obtain funds from other sources. This finding is contrary to the implications of the pecking-order theory. There is also little support for the signaling theory, as very few firms issue stock to give a better impression of the firm. 3. Convertible Debt Policy

More than half of the respondent firms in our sample have issued convertible debt during the last ten years. Table V shows that managers value convertible debt highly as an inexpensive way to issue “delayed” common stock (mean rank 2.45) and for the “ability to call” or the flexibility to force conversion of convertible debt when they want to (mean rank 2.43). This result is consistent with the asymmetric information theory.

Managers also cite the option to issue convertible debt when equity is undervalued (mean rank 2.4), and avoiding short-term equity dilution, as important advantages of issuing convertible debt (mean rank 2.16). This finding supports the responses on common stock policy. Few managers issue convertible debt because it is less expensive than straight debt, or to attract investors who are unsure about the riskiness of the firm. Factors that relate to agency theory, such as protecting bondholders against the actions of stockholders or managers, are considered unimportant. Insert Table V 4. Foreign Debt or Equity Policy

58 % of the respondent firms have raised capital in foreign markets. Managers of these firms cite hedging considerations as the most important factors (Table VI). Sixty-seven percent of managers (mean rank 2.7) cite providing a natural hedge and matching sources and uses of funds as important or very important. Favorable tax treatment relative to Europe and better market conditions are also ranked modestly important (mean ranking of about 2). We are surprised to find that managers consider the level of interest rates as important when issuing debt on the domestic market, but not when issuing it in foreign markets (mean rank 1.48).

In summary, our evidence provides medium support for the trade-off theory but less support for the pecking-order and agency theories. For example, few firms use debt when recent profits are not sufficient to support firm’s activities as predicted by the pecking order. Factors relating to the agency costs, such as to motivate managers

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to work hard or to borrow short-term to reduce the chance that firm will undertake risky projects, are considered unimportant (Table III). Insert Table VI

B. Univariate Tests: Ranking of Different Factors

We compare European and U.S. managers’ rankings of different factors and across legal systems.

1. Comparison of European and U.S. Managers’ Rankings

In Tables III-VI, columns 1 through 4, we compare European and U.S. managers’ rankings of different factors. Two observations follow from this comparison. First, that the relative rankings of most determinants of capital structure are strikingly similar between the two groups. This finding holds for all components of the capital structure choice. For instance, both the European and U.S. groups rank financial flexibility and credit rating as the most important factors of their debt policy, and earnings per share dilution the most important factor of their equity policy. Similar patterns emerge when we compare convertible debt and foreign capital raising policies.

We test the equality of the paired relative rankings for all factors across the two groups, using the parametric t-test and nonparametric Wilcoxon Signed Rank test. The values of both test statistics (about 0.16) are not significant at any reasonable level. This result supports Hypothesis 1, that European and U.S. managers use similar factors in making their financing decisions. Our results confirm Graham and Harvey (2001) conclusions that there is modest support for the trade-off and pecking order theories, but less for the asset substitution, transaction costs, and free cash flow hypotheses.

Second, although the relative rankings of different factors are almost identical across European and U.S. managers, the mean ratings for some factors, such as financial flexibility, are significantly different between the two groups (3.39 compared to 2.59). These differences could be attributed to both demographic and country-specific differences. . 2. Comparisons of Rankings Across Legal Systems

The last ten columns in Tables III-VI present the t-tests for the equality of the mean ratings for each factor across the English, French, German, and Scandinavian law systems. The t-tests show significant differences for several factors. Some of these differences appear to be consistent with the quality of the country’s legal system. For instance, we would expect that concern for financial flexibility or for matching maturity would be higher in civil law systems compared to that in common law systems, because of less availability of external financing in civil systems (see La Porta, Lopez-de-Silanes, Shleifer, and Vishny, 1997, 1998). Our evidence supports this contention.

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However, there are also some notable differences on some dimensions, even across systems of similar quality. For instance, although the quality of German and Scandinavian systems is similar, managers’ concerns about the potential cost of bankruptcy are significantly different across systems (rating of 1.35 compared to 2.23). The Scandinavian managers appear to have significantly different views than their peers on common stock policy. For instance, all non-Scandinavian managers (mean rank about 3) rank earnings per share dilution as the most important determinant of common stock policy, but Scandinavian managers consider it unimportant (mean rank 1.56).These differences might reflect the influence of firm- and country-specific factors. We need to control for these factors if we are to draw meaningful conclusions. III. Cross-Country Analysis

We examine whether the cross-sectional differences in managerial rankings of different factors in our sample can be explained by the country- and firm-specific factors that are often used in the capital structure literature. A. Country-level and Firm-specific Variables We discuss country-level and firm-specific variables that we use in the cross-sectional regression analysis. 1. Country-level variables

We use eight institutional variables as our proxies for the institutional environment of a country (see Table VII for the detailed description of the variables). From La Porta, Lopez-de-Silanes, Shleifer, and Vishny (1997, 1998) we obtain two variables that measure the quality of investors’ rights in the country. The creditors’ rights index (CRRHT) is an index that ranges between zero and four and measures the rights creditors have in bankruptcy. The shareholders’ rights index (SHRHT) is an index that ranges between zero and five and measures the rights of minority shareholders of the firm.

Three variables measure the developments of capital markets in a country. DEBT/GNP is the ratio of the sum of bank debt of the private sector and outstanding non financial bonds to gross national product in 1994. We obtain this measure from La Porta, Lopez-de-Silanes, Shleifer, and Vishny (1997). TOVER is the ratio of the total value of shares traded on the stock exchange divided by the market capitalization in each country (based on 1989-1996 averages). MARKET is a dummy variable that takes the value of one for market-based financial systems and zero for bank-based systems. We obtain both MARKET and TOVER from Demirgüç-Kunt and Maksimovic (2002).

We use three variables as our proxies for the corporate tax rate, cost of capital, and corporate ownership structure in a country. The firm’s corporate tax rate (TAX) is the tax rate on undistributed corporate profits. The cost of capital (COC) is the pre-tax rate of return

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required in each country on a hypothetical investment project with a post-tax required real rate of return 5 %. However, COC is determined using different sources of financing and thus reflects the average effect of corporate tax rates. We obtain this variable from Devereux, Spengel, and Lammersen (2003). They calculate the average for different types of assets purchased, such as intangibles, industrial buildings, machinery, financial assets, and inventories, by using the following weights for different financing sources: retained earnings (55%), new equity (10%), and debt (35%). Data are available for 14 of the 16 countries in our sample.

We measure corporate ownership concentration by using the average percentage of common shares owned by the three largest shareholders in the ten largest nonfinancial corporations (OWN10) in the country, as compiled in La Porta, Lopez-de-Silanes, Shleifer, and Vishny (1998).

Table VII, Panel A shows that the mean (median) values for the country-specific variables are significantly different across legal systems for almost all variables. Further, many of the variables vary substantially across countries even within legal systems (not tabulated). For example, in the Scandinavian law countries. The creditors’ rights index varies from a low of one (Finland) to a high of three (Denmark), but the shareholders’ rights index varies from a low of two (Denmark) to a high of four (Norway). The corporate tax rates vary from a minimum of 25 % (Finland) to a maximum of 54 % (Germany) and the cost of capital from a minimum of 4.8 % (Italy) to a maximum of 7.5 % (France) in our total sample of countries. The mean ownership concentration in our total sample is 42 % but it varies from a minimum of 19 % (U.K.) to a maximum of 67 % (Greece). Insert Table VII 2. Firm-Specific Variables The capital structure literature suggests that leverage increases with firm size and decreases with a firm’s growth opportunities, volatility of earnings, probability of bankruptcy, and managerial ownership (Harris and Raviv, 1991). To capture these effects we use five firm-specific variables for which the firms self-report data. SIZE is the natural log of the market capitalization of the firm and measures the firm size. P/E ratio measures the growth opportunities of a firm, and INDUSTRY (manufacturing, energy, and transportation compared to others) measures the industry effects. MGMTOWN is a dummy variable that takes the value of zero for firms with managerial ownership less than 5 %, and one otherwise.

We also use two variables to examine the impact of international operations of a firm on its capital structure: FRNLST is an indicator variable for firms listed on foreign exchanges. FRNSALE is an indicator variable that takes a value between one and four, based on the percentage of the firm’s foreign sales. Higher scores indicate a higher level of foreign sales.

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Myers (1977) argues that firms with higher agency costs can either limit their total debt or use short-term debt to minimize underinvestment problems in the presence of agency costs. We use the percentage of short-term debt to total debt (%SHRTDEBT) as our proxy for agency costs. Firms in our sample that have a higher %SHRTDEBT are also more likely to say that they borrow short-term because it reduces the chance to undertake risky projects, consistent with the agency theory. However, we use caution in interpreting this variable, since about one third of our sample also use short-term debt as a temporary financing while they are waiting for the long-term interest rates to come down.

Table VII, Panel B, shows that means (medians) of firm size, P/E ratios, and industry composition are similar across different legal systems. However, there are some notable differences for some variables. For instance, the English legal system countries have a much higher percentage of foreign listed firms relative to the countries in other legal systems. On the other hand, the average percentage of short-term debt, is lower in English and French law countries (about 29 %) compared to German and Scandinavian law countries (about 44 %). B. Cross-Sectional Regression Analysis

For this analysis, we focus on the 11 factors that at least 50% of the respondents identify as major determinants of debt and common stock policies. For each factor, we estimate the following cross-sectional regression:

[ ] [ ][ ] 3

21]

-

- [

iji

jijiiijSpecificFirm

SpecificCountrySystemsLegalRank Response

∈++

++=

β

ββα (1)

where Response Rank(ij) is the rating of factor i by respondent j and varies between zero and four,, with four as very important and zero as not important. The legal system variables are the three dummy variables representing the French, German, and Scandinavian legal systems, and the country and firm-specific variables are those just discussed.

We perform the analysis in two steps. First, we run univariate regressions for each of the country and firm-specific variable and then run two multivariate regressions. The first multivariate regression includes only the three dummy variables representing the French, German, and Scandinavian legal systems. The second multivariate regression is the same as the first one but also includes those country- and firm-level variables that have significant coefficients in the univariate regressions at less than 0.10 level. For brevity, we do not report the results of the multivariate regressions but summarize our main findings and their implications in Table VIII. We first discuss the results for each of the factors examined and then summarize our findings.

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Insert Table VIII 1. Debt Policy Factors Financial Flexibility: The need for financial flexibility should be inversely related to the size of capital markets and the quality of legal system of a country. Our results show that while flexibility is negatively related with creditors’ rights (CRRHT) in individual regressions, neither DEBT/GNP nor TOVER is significant in the individual regressions.

However, financial flexibility is less of a concern for managers in countries with market-based financial systems. In fact, the coefficient of MARKET remains robust to the inclusion of other country- and firm-specific variables in the regression, but CRRHT loses significance in this regression. Firms with a larger managerial ownership are also more concerned with financial flexibility. This finding is consistent with Jensen’s (1986) agency theory. Financial flexibility is also positively related to the degree of foreign sales of the firm. This result could reflect the higher growth opportunities and, consequently, a higher need for flexibility for such firms. Credit Rating: Since credit rating provides a signal to investors about the quality of a firm, the value of and need for this signal is likely to be higher in countries with weak shareholders’ rights (SHRRHT) and creditors’ rights (CRDRHT). Contrary to our expectations, neither of the two variables is significant in the individual regressions. Credit rating is also valued more by firms in countries with a relatively higher cost of capital, which suggests that its ranking could be driven by the need of firms in such countries to tap international capital markets.

To examine this issue, we run a multivariate regression by including the three legal system variables and an indicator variable (FRNISSUE) for firms that have issued debt or equity in foreign markets during the last ten years. The coefficient of FRNISSUE is positive and is the only significant variable in this regression (coefficient 1.06, t-value 3.95) that supports the idea that the concern for credit rating is influenced by the firm’s need to access international capital markets. Firm size is also positively related to this factor, but most of its significance comes from firms that have a credit rating. Tax Advantage of Debt: We expect to find that the cross-country variation in tax advantages of debt is positively related to tax and cost of capital variables. Our analysis shows that the coefficient of cost of capital is positive and significant at the 0.1 level in the individual regression, as predicted, but that the coefficient of TAX has a negative sign, opposite to what we expected. The results are qualitatively similar when we use the other proxies of corporate tax rates discussed in La Porta, Lopez-de-Silanes, Shleifer, and Vishny (2000).

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The nonsignificance of tax variables could be because of the difficulty in estimating the effective tax rates for firms. Effective tax rates are likely to be different from the statutory tax rates (see Graham, 1996). We note that multinational firms and firms with a higher percentage of short-term debt are also more concerned about the tax advantage of debt. This result support the idea that firms decide their optimal capital structures by using different trade-offs of costs and benefits. Earnings Volatility: Since firms with high earnings volatility have a higher probability of default, investors are less likely to provide financing to such firms, especially in countries with weak creditors’ rights. The results support this prediction. We find that this factor is negatively correlated with the creditors’ rights index, and is the only country-specific variable that is significant in the multivariate regression. This result is also consistent with the agency theory, because agency costs of debt are likely to be higher in countries with weaker investor protection.

Weighted Average Cost of Capital (WACC): This factor is likely to be positively related to the cost of capital and tax variables, but neither of the two is statistically significant in any regression. This result could be partly attributed to the problems of measuring the appropriate tax rates for different firms. However, firms with a higher percentage of short-term debt have significantly lower concerns about this factor. This lack of concern suggests that in deciding their optimal capital structures firms may trade off the reduction of agency costs against the advantages of debt. Matching Maturity: To manage the risk of refinancing in bad times, managers commonly match the maturity of assets with liabilities. The need for and value of this tool are likely to be higher for firms located in countries with a lower level of the quality of their legal systems. Our results support this prediction, as managers in civil-law countries value this factor much more highly than do their peers in common-law countries. Financing in Bad Times:This factor is also likely to be inversely related to the quality of the legal system. Our results support this prediction. The creditors’ rights index is the only significant country-level variable. It has a negative coefficient, as expected, and also remains robust to the inclusion of firm-specific variables in the regression. Firms with a higher percentage of short-term debt are also less concerned about financing in bad times, a finding that is consistent with their views on matching maturity and minimizing the cost of capital. 2. Equity Policy Factors Earnings Per Share Dilution (EPS): The results show that managers in Scandinavian legal system countries are significantly less concerned about the EPS dilution than are their peers in other countries. Two country-specific variables, DEBT/GNP and OWN10, are also significant in separate individual regressions, with a positive and

13

negative sign, respectively. However, neither is significant when we include both variables in the regression.

We find similar results when we analyze the factor pertaining to the use of debt because of close relationships with a bank that is also ranked significantly higher by the Scandinavian managers compared to other managers (untabulated). This result suggests that DEBT/GNP and OWN10 may be proxies for the effect of some omitted factors that differ across Scandinavian and non-Scandinavian countries, or they could just reflect random chance. For example, the ranking of this factor may depend on whether the managerial compensation in the firm is based on the earnings per share or not. Target Debt-to-Equity: The trade-off theory predicts that this factor should be positively related to the tax and cost of capital variables. Alternatively, managers may use the target debt-to-equity ratio primarily to manage the riskiness of debt. In that case it should be negatively related to the quality of legal systems, because of the potentially higher cost of bankruptcy in systems with poor creditor protection. The results support the latter explanation, because managers in civil-law systems have significantly higher concerns for maintaining target ratios relative to their common-law peers. Managers of multinational firms and foreign listed firms are also more concerned, and managers of firms that rely more on short-term debt are less concerned about maintaining target ratios. This finding implies that firms may decide their capital structure by trading off different costs and benefits. High Stock Price: This factor is related to managers’ use of windows of opportunity in issuing common stock and is likely to be a universal factor. The results generally support this prediction, because none of the country-specific variables are significant when we include the firm-specific factors in the regression. The price to earnings ratio (P/E) is the only significant explanatory variable in this regression. Growth firms are likely to rely more on equity financing and may be more concerned with the stock price at the time of the equity issue. This finding is consistent with the asymmetric information theory. Under- or Overvalued Stock: This factor is also related to managers’ beliefs about valuation of the firm’s stock. We expect it to be portable across countries. The results support this prediction. High-growth firms are also more concerned about stock valuation when issuing equity. This finding supports the asymmetric information theory.

The evidence shows that cross-sectional differences in the rankings of several

factors including earnings volatility, matching maturity, financing in bad times and target ratios are explained primarily by the legal system variables in a predictable

14

manner. For example, firms in countries with lower protection of creditors’ rights are more concerned about earnings volatility and financing in bad times, as expected. This evidence provides moderate support for hypothesis 2 but less support for hypothesis 3 because most of these factors relate to the debt policy and not the equity policy. Our evidence also supports that increased accessibility to global capital markets also influences a firm’s ranking of some factors.

B. Robustness Checks We conduct several robustness checks to examine the sensitivity of our results.

First, we redo our analysis by replacing legal system dummies in the regressions with the country-level indexes for effectiveness of law and rule-of-law as compiled and discussed in La Porta, Lopez-de-Silanes, Shleifer, and Vishny (1997, 1998). The results are qualitatively similar to those presented above when we use country-level indexes although the significance of creditors’ rights index increases in most regressions.

We use an ordered probit model instead of an ordinary least squares model for analysis. The estimated coefficients and their significance in all regressions are similar in both models.

We also examine the sensitivity of our results to the CEO characteristics and other demographic variables such as influence of shareholders (INFLSHR) discussed in Table II. Our results remain essentially the same.

We also compare our results with those in Brounen, Jong, and Koedijk (2004) who survey managers from four European countries, U.K., The Netherlands, Germany and France on the theory and practice of corporate finance. They analyze cross-country variation in managerial rankings of four determinants of capital structure in their sample: flexibility, target ratios, tax advantage and bankruptcy costs. It is reassuring that they also report that flexibility and tax advantage factors do not vary significantly across countries, consistent with our findings. However, they find that firm size is the dominant explanatory variable and national differences play only a weak role in explaining cross-sectional variation in factor rankings in their sample. In contrast, we find strong evidence that debt policy factors vary systematically with the quality of the legal system in the country. One plausible explanation for these differences could be that their sample comprises of both large and small firms while our sample consists mainly of large and well-known European firms. In addition, our conclusions are based on the analysis of eleven factors compared to four examined in their study.

We also examine factors that are ranked as unimportant (minor) by managers, but find that their rankings differ significantly across legal systems (Tables III-IV). Our analysis (not tabulated for brevity) shows that the firm-specific factors explain most of the variation in the minor factors, and that the institutional variables have very little explanatory power. Firm size and growth opportunities are the major

15

explanatory variables for the factors relating to debt and equity policies, respectively. Further, the correlations of the firm-specific variables with the factors are

consistent with the predictions of the capital structure theories. For instance, large firms care less about the potential cost of bankruptcy, a finding that is consistent with their lower agency costs. Firm size also explains the differences in bankruptcy costs for the German and Scandinavian countries that we noted in Table III, Panel A (b). Larger firms with insufficient recent profits also care less about issuing debt. This result is consistent with their lower agency costs and asymmetric information relative to their smaller peers (see Table III, Panel B (a)). Table IV (d) shows that high-growth firms are more likely to consider common stock is the cheapest source of funds, which is consistent with the asymmetric information theory. Industry and managerial ownership also have explanatory power in some cases, which supports the theoretical literature

IV. Summary and Conclusions In this study, we compare managerial views on the determinants of capital structure

across 16 European countries. Our goal is to gain some insights into the following questions: Are financing policies of European and U.S. firms driven by similar factors? Are cross-country differences in managerial views explained primarily by the legal institutions, or do other institutions also play a major role? And which factors underlying debt and equity policies are more sensitive to the institutional environment and which are portable across countries?

Our conclusions are as follows. First, European managers use factors similar to those used by their U.S. peers for their financing decisions. However, there are differences across countries on several dimensions, especially between Scandinavian and non-Scandinavian countries. Second, the quality of the country’s legal system explains cross-country variations in the rankings of several major factors, but so do other country-specific factors such as cost of capital. In addition, although differences in debt policy factors vary systematically with the quality of a country’s legal system, firm-specific factors such as the firm’s growth opportunities strongly influence the common stock policy factors.

Our results should be interpreted with some caution because of potential biases and measurement problems that are normally associated with survey data. Surveys measure beliefs and may not represent the reality in the field.

Another concern is that managers’ responses may not appropriately reflect their views on the implications or assumptions of the theories. In addition, the problems of endogenity and high correlations among some of the variables used in our analysis weaken the statistical power of our tests. We find that the Scandinavian managers’ views on capital structure differ significantly from their other civil-law peers, especially on equity, convertible debt, and raising foreign capital. These differences

16

could reflect random chance, or differences in the population of firms, or the effect of other institutions, such as moral and ethical norms not accounted for in our study. However, we are unable to pinpoint the source of these differences because there are several factors, such as the effective tax rates and ownership structure for firms that we cannot measure.

To examine some of these biases, we present our results to two different groups, business executives and senior investment bankers. Both groups agreed with our major conclusions. They also provided some examples based on their experience that illustrated how country-specific institutions and regulations could impact the financing choices of firms across countries that have the same legal system. Their feedback indicates the robustness of our findings and also suggests future research, in that cross-country research requires more refined country-level variables for more informative analysis.

Nevertheless, our study provides insights into cross-country determinants of leverage that are difficult to obtain through traditional empirical studies. We show that factors related to debt are influenced more, and those related to equity are influenced less, by the country’s institutional structure, especially the quality of its legal system. This evidence strengthens arguments of La Porta, Lopez-de-Silanes, Shleifer, and Vishny (1997, 1998) that the availability of external financing in a country is influenced primarily by its legal environment. Since agency costs of debt are likely to be higher in countries with lower quality of legal systems, this evidence is also consistent with theories of capital structure such as agency theory that assign a central role to debt contracts and bankruptcy law (Harris and Raviv, 1991).

However, we also show that firms can adopt strategies to mitigate the negative effects of the quality of the legal environment in their home country. For instance, firms in civil-law countries have significantly higher concerns for maintaining target debt–to-equity ratios and matching maturity than do their peers in the common-law countries. Further, we find that firms operating internationally have significantly different views than do their peers in several ways. For example, firms that have issued foreign debt or equity in our sample during the last ten years are more concerned about credit ratings. We also show that firm-specific variables that are commonly used in the capital structure literature to explain leverage also explain cross-country differences in managerial rankings of several factors. For example, large firms are less concerned about bankruptcy costs, and high growth firms consider common stock as the cheapest source of funds and use windows of opportunity to issue common stock. These results support that firms’ capital structures are the result of a complex interaction of several institutional features as well as firm characteristics in the home country, as argued by Rajan and Zingales (1995, 2003).

Overall, our results support that most firms determine their optimal capital structure by trading off factors such as tax advantage of debt, or bankruptcy costs, agency costs, and

17

accessibility to external financing. We also confirm the conclusions of Titman (2001): “Corporate treasurers do occasionally think about the kind of trade-offs between tax savings and financial distress costs that we teach in our corporate finance classes. However, since this trade-off does not change much over time, the balancing of the costs and benefits of debt financing that we emphasize so much in our textbooks is not their major concern. They spend much more time thinking about changes in market conditions and the implications of these changes on how firms should be financed”.

18

REFERENCES Booth, L., Aivazian, V., Demirgüç–Kunt A. and V. Maksimovic, 2001, “Capital structures in developing countries”, Journal of Finance 56, 87-130. Brounen, D., Jong, A., and K. Koedijk, 2004, “Corporate Finance in Europe Confronting Theory with Practice”, Erasmus University Rotterdam working paper. Demirgüç-Kunt, A. and V. Maksimovic, 1999, “Institutions, financial markets and firm debt maturity”, Journal of Financial Economics 54, 295-336. Demirgüç-Kunt, A. and V. Maksimovic, 2002, “Funding growth in bank-based and market-based financial systems: Evidence from firm-level data”, Journal of Financial Economics 65, 337-363. Devereux, P., Spengel, C., and L. Lammersen, 2003, “Corporate taxes and inefficiency in Europe”, National Tax Journal, Proceedings of the 95th Annual conference, 226-235. Doukas, J., and Pantzalis, C., 2003, “Geographic diversification and agency costs of debt of multinational firms”, Journal of Corporate Finance 9, 59-92. Graham, J., 1996, “Proxies for the corporate marginal tax rate”, Journal of Financial Economics 42, 187-221. Graham, J. and C. Harvey, 2001, “The theory and practice of corporate finance: Evidence from the field”, Journal of Financial Economics 60, 187-243. Harris, M., and A. Raviv, 1991, “The theory of capital structure”, Journal of Finance 46, 297-355. Jensen, M., 1986, “The agency costs of free cash flow, corporate finance and takeovers”, American Economic Review 76, 323-329. La Porta, R., Lopez-de-Silanes F., Shleifer A. and R. Vishny, 1997, “Legal determinants of external finance”, Journal of Finance 52, 1131-52. La Porta, R., Lopez-de-Silanes F., Shleifer A. and R. Vishny, 1998, "Law and finance”, Journal of Political Economy 106, 1113-1155. La Porta, R., Lopez-de-Silanes F., Shleifer A. and R. Vishny, 2000, “Agency problems and dividend policies around the world”, Journal of Finance 55, 1-33. Myers, S., 1977, “Determinants of corporate borrowing”, Journal of Financial Economics 5, 147-175. Pagano, M., Röell, A., and J. Zechner, 2002, "The geography of equity listing: why do European companies list abroad?”, Journal of Finance 57, 2651-2694. Rajan, R. and L. Zingales, 1995, “What do we know about capital structure? Some evidence from international data”, Journal of Finance 50, 1421-1460.

19

Rajan, R. and L. Zingales, 2003, “Banks and Markets: The Changing Character of European Finance”, University Of Chicago, Working Paper. Titman, S., 2001, “The Modigliani and Miller: Theorem and Market Efficiency”, NBER working paper no. W8641.

20

Legal System of the Country of Origina

No. of Sample Firms

Percentage of Sample Firms

Percentage of Respondents

P -valuebc

French Law Countries 323 44,86% 45.98% 0.91 (0.15)France 113 34,98% 32.5% 0,86Belgium 21 6,50% 2.5% 0,49Greece 29 8,98% 12.5% 0,40Italy 59 18,27% 10,00% 0,27Portugal 14 4,33% 12.5% 0.045**Spain 47 14,55% 17.5% 0,64The Netherlands 40 12,38% 12.5% 1,00German Law Countries 139 19,31% 24.14% 0.32 (0.88)Germany 95 68,35% 71.43% 0,81Austria 18 12,95% 9.52% 0,75Switzerland 26 18,71% 19.05% 1,00Scandinavian Law 105 14,58% 16.09% 0.75 (0.45)Denmark 26 24,76% 35.71% 0,52Finland 26 24,76% 35.71% 0,52Norway 31 29,52% 14.29% 0,34Sweden 22 20,95% 14.29% 0,73English Law Countries 153 21,25% 13.79% 0.16 (0.28)United Kingdom 141 92,16% 83.33% 0,27Ireland 12 7,84% 16.67% 0,27Total 720 100,00% 100.00% 0,35

cWe compute the p -values in parentheses using the multinomial (Chi-square) test that the proportions ofrespondent firms across countries within each legal system proportions of respondent firms acrosscountries within each legal system are the same as in the population (720 firms). The value 0.35 in the lastrow and last is the p-value for the multinomial test that the proportions of respondent firms across differentlegal systems are the same as in the population ie. 44.86%, 19.31%, 14.58%, and 21.25% respectively.

Table ITests of Nonresponse Bias across Legal Systems and Country of Origin

aBased on La Porta, Lopez-de-Silanes, Shleifer and Vishny (1997).bWe compute the p -values using the Fisher's Exact Test for testing that the proportion of respondent firmsin each country or in each legal system is the same as in the population.

21

SIZE (Small to

large)

P/E (low to high)

D/E (low to high)

Dividends (yes to no)

Rating (high to

low)

Industry (manu/ energy/ transp. /others)

Ownership (high to low)

Age (young to mature)

Tenure (short to

long)

Education (MBA to others)

Utility (yes to

no)

Equity (public to private)

For. Rev (High to

low)

Target D/E

(no to yes)

FRNLST (no to yes)

Inflshr no<=2 (no to yes)

Inflbond (no to yes)

Inflempl (no to yes)

Inflgovt (no to yes)

Infllocgovt (no to yes)

Multiple (no to yes)

issuestk (no to yes)

freefloat<50% (low to

high)

eqcost<median 9.5 (low to high)

CAPM (use or

not)

Panel A:P/E -0.24**D/E -0.08 -0.15Dividends -0.17 0.09 0.32**Rating 0.17 -0.17 0.09 -0.11Industry -0.12 0.2 0.11 0,00 0.14Ownership -0.20* 0.26** 0.07 -0.09 -0.01 -0.07Age -0.06 0.02 0.08 -0.11 0.01 -0.02 -0.09CEOtenure 0.03 0.05 -0.06 -0.05 -0.01 0.21 0.08 0.43***Education -0.21* -0.11 0.24* -0.05 0.11 0.09 -0.05 0.18 0.08Utility 0.16 -0.09 -0.05 0.07 -0.02 -0.04 -0.03 0.01 -0.21* -0.08Equity 0.02 0.06 0.14 -0.04 0.05 0.03 -0.03 0.1 0.24** -0.18 -0.24**FRNSALE 0.21* -0.01 -0.07 0.13 0.19* -0.30** -0.1 0.11 -0.08 0,00 0.27** 0.05Target D/E -0.09 -0.23* 0.1 -0.03 0.09 -0.14 0.15 0.17 0.11 -0.02 0.01 -0.09 0.01FRNLST 0.46*** -0.02 0.07 0.04 0.06 -0.04 0.01 -0.1 -0.01 -0.08 0.11 -0.19* 0.22* 0.09

Panel B:Inflshr 0.09 0.03 0.1 0.07 -0.25 -0.09 -0.04 0.06 -0.03 0.16 0.11 0.07 0.12 0.03 0.1Inflbond 0.08 0.05 0.11 -0.1 0,00 0.13 -0.09 0.07 -0.01 0.02 -0.02 -0.08 0.03 -0.04 -0.11 0.05Inflempl 0.03 0.03 0.01 0.08 0,00 0.03 0.1 -0.15 -0.20* 0.09 0,00 0.08 0.03 -0.17 -0.04 0.15 0.17Inflgovt -0.05 0.08 -0.13 -0.09 0.08 0.01 0.17 0.04 0.05 0.03 -0.05 0.11 -0.09 0.03 -0.03 -0.08 0.04 0.25**Infllocgovt -0.13 0.1 -0.22* -0.06 0,00 -0.06 0.26* -0.14 0,00 -0.22* 0.08 0.1 0.09 -0.21* -0.03 -0.22** -0.14 0.12 0.52***Multiple 0.12 -0.05 0.23* -0.14 0.06 0.06 0.22 -0.25** 0,00 -0.36** -0.11 0.28** -0.03 0.08 0.08 0.03 0.04 0.01 0.1 0.07issuestk 0.13 0.36*** 0.04 0.14 0.02 0.12 0.02 0.17 -0.01 -0.11 0.16 0.08 0.04 0.13 0.11 0.04 0.12 0.03 0.04 0.02 -0.27**freefloat 0.12 0.23* -0.19 0.18 0.33* -0.01 -0.03 0.02 -0.09 -0.01 0.19 -0.22* 0.21* -0.01 0.09 -0.21** 0.05 -0.17 -0.21** -0.22** -0.12 -0.01eqcost 0.05 -0.22 0.22* 0.09 0.07 -0.17 -0.12 0.03 -0.21 0.17 0.01 -0.12 0.17 0.01 0.17 0.14 0.2 0.17 0,00 -0.08 -0.14 0.08 0.02CAPM 0.04 0.18 0.05 -0.05 -0.09 0.1 -0.11 0.11 0.05 0.21* 0.39*** -0.16 0.08 -0.08 -0.13 0.15 0.05 -0.08 0.09 0.12 -0.16 0,00 0.13 -0.23**%shrtdebt -0.13 0.00 -0.42*** -0.17 -0.08 -0.17 0.03 -0.16 0.04 -0.11 0.07 0.14 0.02 -0.32** 0.04 -0.10 -0.26** -0.05 0.03 0.25** 0.23 -0.16 -0.04 -0.08 0.03

*Significant at the 0.10 level.

***Significant at the 0.01 level.**Significant at the 0.05 level.

Correlations of Control variables from the SurveyTable II

We report Kendall’s Tau, a measure of correlation between two ordinal-level (rankable) variables. Panel A: Size (large firms have market capitalization greater than 5,000 million euro), P/E (growth firm has P/E ratio greater than 14), D/E (leveraged firm has debt to equity greater than 0.3), Dividends (whether the firm pays dividends), Rating(high has debt rated BBB or above), Industry (manufacturing / energy / transportation versus all others), Ownership (high is managerial stock ownership is greater than 5%), Age (CEO older than 59 versus younger than 60), CEOtenure (long is nineor more years on the job), Education (whether the CEO has an MBA), Utility (whether the firms is regulated), Equity (public versus private, family or government controlled corporations), FRNSALE (whether foreign sales are greater than 25% oftotal sales), Target D/E (whether the firm reports a target debt ratio), FRNLST (whether listed on foreign stock exchanges or not). Panel B: first five variables, inflshr, inflbond, inflemp, inflgovt, inflgovt, measure whether influence of shareholders, bondholders, employees, government, and local government respectively on financing decisions of the firm is high or low. OtherPanel B variables include Multiple (multiple classes of shares or not), issuestk (shares issued in last ten years or not), free float (percentage of free float of shares is low (<50%)), eqcost (estimated cost of equity), CAPM (use CAPM or not forestimating cost of equity), and %shrtdebt (percentage of short term debt is low to high ( >40% of total debt).

22

Important or very

important (%)

Mean

Imp. or very imp. (%)

ALL English Law

French Law

German Law

Scand. Law

English Law = French

Law

English Law =

German law

English Law = Scand. Law

French Law =

German Law

French Law = Scand. Law

GerLawScand. La

g) Financial flexibility 90.80 3.39 59,38 2.59 3.00 3.48 3.43 3.43 ** * *

d) Our credit rating (as assigned by rating agencies) 73.17 2.78 57,10 2.46 2.58 2.58 3.14 2.92 *

a) The tax advantage of interest deductibility 58.14 2.59 44,85 2.07 2.92 2.87 2.33 1.93 * ** * ***

m) The volatility of our earnings and cashflows 50.00 2.33 48,08 2.32 2.00 2.42 2,30 2.42

e) The transactions costs and fees for issuing debt 33.33 1.94 33,52 1.95 1.41 2.05 2.29 1.57 *

h) We limit debt so our customers/suppliers are not worried about our financial stability

32.56 1.97 18,72 1.24 1.17 2.18 2.10 1.86 ** **

b) The potential costs of bankruptcy or near bankruptcy financial distress

30.95 1.76 21,35 1.24 1.58 1.87 1.35 2.23 *

c) The debt levels of other firms in our industry 23.26 1.84 23,40 1.49 1.67 1.85 1,90 1.86

f) The personal tax cost that our investors face when they receive interest income

10.59 0.96 4,79 0.68 0.50 1.11 1.19 0.64 * *

l) To ensure that upper management works hard and efficiently

6.98 0.73 1,69 0.33 0.83 0.75 0.67 0.69

i) We try to have enough debt so that we are not an attractive target

4.65 0.85 4,75 0.73 0.75 0.85 0.86 0.92

j) If we issue debt our competitors know that we are very unlikely to reduce our output

1.16 0.44 2,25 0.40 0.17 0.55 0.52 0.23 ** * *

k) A high debt ratio helps us bargain for concessions from our employees

0.00 0.27 0,00 0.16 0.25 0.25 0.43 0.08 *

***Significant at the 0.01 level.**Significant at the 0.05 level.*Significant at the 0.10 level.

U.S.

Panel A: What factors affect how you choose the appropriate amount of debt for your firm?

European

We asked respondents to rate on a scale of 0 (not important) to 4 (very important). We report the overall mean as well as the % of respondents that answered 3 a4 (important and very important).

Table IIISurvey responses to questions relating to the debt policy of the firm

European Countries Univariate T -test for Difference in Means (P -valu

man =

w

*

*

nd

e)

23

Imp. or very imp. (%)

ALLEnglish

Law French

Law German

LawScand. Law

English Law = French

Law

English Law =

German law

English Law = Scand. Law

French Law =

German Law

French Law = Scand. Law

German Law = Scand. Law

i) With the use of debt, we try to minimise the weighted average cost of capital 69.77 2,80 NA NA 2.33 3.00 2.81 2.62

c) We issue debt when interest rates are low 44.83 2.10 46,35 2.22 1.17 2.15 2.62 2.00 ** *** *

d) We use debt when our equity is undervalued by the market 43.68 2.08 30,79 1.56 1.92 2.23 1.86 2.14

a) We issue debt when our recent profits are not sufficient to fund our activities 24.14 1.56 46,78 2.13 1.00 1.80 1.57 1.36 *

b) Using debt gives investors a better impression of our firm’s prospects that issuing stocks 20,00 1.55 9,83 0.96 1.30 1.83 1.24 1.43 **

g) Changes in the price of our common stock 15.12 1.34 16,38 1.08 1.08 1.43 1.33 1.31

j) We prefer banks to bonds because it avoids our firm to disclose too much information 14.12 1.02 NA NA 0.91 1.13 1.00 0.85

f) We delay issuing or retiring debt because of transactions costs and fees 5.81 0.92 12,43 1.04 1.33 1.03 0.71 1.13

e) We use debt because of our close relationship with a bank (house bank) 3.49 0.73 NA NA 0.92 0.64 0.48 1.21 * **

h) We issue debt when we have accumulated profits 1.18 0.72 1,14 0.53 0.91 0.73 0.62 0.69

b) Matching the maturity of our debt with the life of our assets 77.01 3.10 63,25 2.60 2.48 3.43 3.19 2.93 ** *** *

f) We issue long-term debt to minimize the risk of having to finance in “bad times” 69.77 2.83 48,83 2.15 2.42 2.95 2.76 2.92 *

a) We issue short term when we are waiting for long term market interest rates to decline 31.03 1.85 28,70 1.78 1,00 1.80 2.52 1.71 ** *** ** ** **

d) We expect our rating to improve, so we borrow short term until it does 7.14 0.90 8,99 0.85 0.75 0.87 1.10 0.83

c) We borrow short-term so that returns from new projects can be captured by shareholders 5.75 1.02 9,48 0.94 0.75 1.08 1.10 1,00

e) Borrowing short-term reduces the chance that our firm will want to take on risky projects 1.16 0.53 4,02 0.53 0.17 0.65 0.57 0.46 *** ***

***Significant at the 0.01 level.**Significant at the 0.05 level.*Significant at the 0.10 level.

Panel B: What other factors affect your firm's debt policy?

Panel C: What factors affect your firm's choice between short- and long-term debt?

U.S.

Table III (Continued)

Important or very

important (%)

Mean

European Countries Univariate T -test for Difference in Means (P -value)

24

Important or very

important (%)

MeanImp. or

very imp. (%)

ALL English

Law French

Law German

Law Scand. Law

English Law = French

Law

English Law =

German law

English Law = Scand. Law

French Law =

German Law

French Law = Scand. Law

GermLaw =ScandLa

m) Earning per share dilution 66.04 2.72 68,55 2.84 3,20 2.96 2.87 1.56 *** *** *

e) Maintaining a target debt-to-equity ratio 59.26 2.67 51,59 2.26 1.40 2,80 2.73 2.89 ** ** **

a) If our stock price has recently risen, the price at which we can issue is “high” 59.26 2.61 62,60 2.53 2.60 2.88 2.53 2.00 **

k) The amount by which our stock is undervalued or overvalued by the market 53,70 2.44 66,94 2.69 3.20 2.44 2.40 2.11 *

c) Providing shares to employee stock option plan 44.44 2.07 53,28 2.34 1.50 2.11 2.40 2.11

g) Whether our recent profits have been sufficient to fund our activities 32.08 1.94 30,40 1.76 1.00 2.00 2.21 1.89 * *

j) Diluting the holdings of certain shareholders 29.63 1.67 50,41 2.14 1.00 1.76 1.80 1.56

f) Using a similar debt/equity ratio as is used by other firms in our industry

27.78 1.85 22,95 1.45 1.40 1.84 2.13 1.67

b) Stock is our "least risky" source of funds 25.93 1.50 30,58 1.76 2.40 1.72 1.13 1.00 * *

n) In case of paying a target by shares, the ability to use the pooling of interest method

22.00 1.56 NA NA 0.80 1.52 2.14 1.13 *

h) Issuing stock gives a better impression of our firm's prospects than using debt

9.06 1.15 21,49 1.31 1.40 1.16 1.13 1.00

i) The capital gains tax rates faced by our investors (relative to tax rates on dividends)

7.41 0.98 5,00 0.82 0.60 0.96 1.20 0.89

d) Common stock is our cheapest source of funds 7.41 0.67 14,05 1.10 1.00 0.80 0.60 0.22 * *

l) Inability to obtain funds using other sources 5.56 0.93 15,57 1.15 0.80 1.00 0.73 1.11

***Significant at the 0.01 level.**Significant at the 0.05 level.*Significant at the 0.10 level.

Table IVSurve

an .

w

*

y response to the question: Has your firm seriously considered issuing common stock? If yes, what factors affect your firm’s decisions about issuing common stock?

European Countries Univariate T -test for Difference in Means (P -value)

We asked respondents to rate on a scale of 0 (not important) to 4 (very important). We report the overall mean as well as the % of respondents that answered 3 and 4 (important and very important).

U.SEuropean

25

Important or very

important (%)

MeanImp. or

very imp. (%)

ALL English Law

French Law

German Law

Scand. Law

English Law = French

Law

English Law =

German law

English Law = Scand.

Law

French Law =

German Law

French Law = Scand.

Law

German Law = Scand. Law

a) Convertibles are an inexpensive way to issue "delayed" common stock 57.14 2.45 58,11 2.49 2.67 2.67 2,50 1.20 * *

g) Ability to "call" or force conversion of convertible debt if/when we need to 54.76 2.43 47,95 2.29 1.75 2.57 2.10 3.00 **

f) Our stock is currently undervalued 51.16 2,40 50,68 2.34 2.25 2.46 2,30 2.40

e) Avoiding short-term equity dilution 51.16 2.16 45,83 2.18 2.75 2.33 2.22 0.80 *** *** **

c) Convertibles are less expensive than debt

35.71 1.86 41,67 1.85 2.33 1.86 2,00 1.20

h) To attract investors unsure about the riskiness of our firm

26.83 1.68 43,84 2.07 1.00 1.69 1.50 2.75 * ** **

d) Other firms in our industry successfully use convertibles 18,60 1.09 12,50 1.10 1.00 1.08 1.00 1.67

b) Protecting bondholders against unfavourable actions by managers or stockholders

4.65 0.88 1,41 0.62 0.75 0.96 0.90 0.60

***Significant at the 0.01 level.**Significant at the 0.05 level.*Significant at the 0.10 level.

Table VSurvey response to the question: Has your firm seriously considered issuing convertible debt (or issued debt in last ten years)?

If yes, what factors affect your firm’s decisions about issuing convertible debt?

European Countries Univariate T -test for Difference in Means (P -value)European U.S.

We asked respondents to rate on a scale of 0 (not important) to 4 (very important). We report the overall mean as well as the % of respondents that answered 3 and 4 (important and very important).

26

Important or very

important (%)

MeanImp. or

very imp. (%)

ALL English Law

French Law

German Law Scand. Law

English Law = French

Law

English Law =

German law

English Law = Scand. Law

French Law =

German Law

French Law = Scand. Law

German Law = Scand. Law

b) Keeping the "source of funds" close to its "use”

67.35 2.71 63,69 2.67 1.63 3.27 2.73 1.25 ** ** *

c) Providing a "natural hedge" 66.67 2.69 85,84 3.15 1.63 3.24 2.64 1.50 **

a) Favorable tax treatment relative to Europe 52.08 2.06 52,25 2.26 1.50 2.10 2.50 2.00

f) Market conditions may be better than domestic conditions

44,90 2.08 NA NA 1.75 1.96 2.82 1.50 * *

d) Lower interest rates in foreign markets 26.09 1.48 44,25 2.19 0.88 1.44 2.22 1.25 **

e) Foreign regulations require us to issue abroad

20.83 1.23 5,50 0.63 1.75 0.92 1.28 2.00

***Significant at the 0.01 level.**Significant at the 0.05 level.*Significant at the 0.10 level.

European

in the last decade? If yes, what factors affect your firm’s decisions about issuing in foreign markets?

Table VISurvey response to the question: Has your firm seriously considered issuing (or issued) common stock or debt in foreign countries

European Countries Univariate T -test for Difference in Means (P -value)U.S.

We asked respondents to rate on a scale of 0 (not important) to 4 (very important). We report the overall mean as well as the % of respondents that answered 3 and 4 (important and very important).

27

0 English

Law

1 French

Law

2 German

Law

3 Scandi.

Law

English Law = French

Law

English Law =

German Law

EnglishLaw = Scandi.

Law

Panel A: Country SpecificCRRHT 1.94

(2.00)3.50

(4.00)1.10

(1.00) 2.62

(3.00)2.00

(2.00)***

(***)**

(***)***

(***)SHRHT 2.67

(3.00)4.83

(5.00)2.65

(3.00)1.38

(1.00)2.79

(3.00)***

(***)***

(***)***

(***)MARKET 0.20

(0.00)0.83

(1.00)0.13

(0.00)0.00

(0.00)0.14

(0.00)**

(**)***

(***)***

(***)DEBT/GNP 0.82

(0.96)1.01

(1.13)0.75

(0.75)1.08

(1.12)0.56

(0.60)***

(***)

(***)***

(***)TOVER 0.60

(0.50)0.52

(0.50)0.44

(0.47)1.09

(1.25)0.40

(0.42)**

(***)***

(***)***

(***)TAX 0.38

(0.34)0.34

(0.33)0.37

(0.35)0.48

(0.54)0.29

(0.28)

(**)***

(***)** (*)

COC 6.55 (6.50)

6.45 (6.50)

6.60 (6.50)

6.74 (6.80)

6.22 (6.20)

*** (***)

* (***)

OWN10 0.43 (0.45)

0.22 (0.19)

0.47 (0.51)

0.48 (0.48)

0.38 (0.37)

*** (***)

*** (***)

*** (***)

Panel B: Firm SpecificSIZE 8.08

(7.98)8.58

(8.54)8.11

(7.91)7.97

(7.50)7.72

(7.17)P/E 19.43

(16.00)22.50

(17.00)19.30

(15.40)18.40

(17.50)17.86

(12.50)INDUSTRY 1.77

(2.00)1.83

(2.00)1.83

(2.00)1.67

(2.00)1.64

(2.00)FRNLST 0.44

(1.00)0.67

(1.00)0.46

(0.00)0.30

(0.00)0.38

(0.00)** (*)

FRNSALE 3.23 (4.00)

3.64 (4.00)

2.89 (3.00)

3.38 (3.00)

3.50 (3.00)

* (**)

MGMTOWN 1.27 (1.00)

1.25 (1.00)

1.15 (1.00)

1.37 (1.00)

1.43 (1.00)

%SHRTDEBT 0.35 (0.31)

0.30 (0.29)

0.28 (0.29)

0.45 (0.35)

0.43 (0.41)

***Significant at the 0.01 level.**Significant at the 0.05 level.*Significant at the 0.10 level.

Panel B: SIZE measures the firm size and is a natural log of market capitalization of a firm, P/E is thegrowth opportunities of a firm, INDUSTRY is a dummy variable that takes the value zero if the firm betransportation industry and one otherwise, FRNLST is a dummy variable that takes the value one if the fiand zero otherwise, FRNSALE measures the degree of foreign sales and takes the value one if the percenbetween 1-10 percent, two if it is between 10-24 percent, 3 if it is between 25-49, and four if it is greatera dummy variable that proxies the managerial stock ownership and takes the value zero if the managerial5 percent and one otherwise, and %SHRTDEBT is the percentage of short-term debt to total debt of a firdebt.

Mean (median)

Legal systems Mean (median)P-values for univariate T-test for di

difference in med

Table VII

Comparisons of Country and Firm Characteristics Across Different Legal SPanel A: CRRHT (Creditors' rights index) measures the protection of creditors in a country. This vconstructed by adding 1 for each of the four rights: (1) the country imposes restrictions, such as creditor’to file for reorganization; (2) secured creditors are able to gain possession of their security once theapproved (no automatic stay); (3) secured creditors are ranked first in the distribution of the proceeds thaassets of a bankrupt firm; and (4) the debtor does not retain the administration of his property pending thSource: LLSV (1997); SHRHT (Shareholders' rights index) measures the rights of minority shareholdersfrom 0 to 5, and is constructed by adding 1 for each of the five rights: (1) the country allows shareholdfirm; (2) shareholders are not required to deposit their shares prior to the general shareholder’s mproportional representation of minorities in the board of directors is allowed; (4) an oppressed minorities mechanism is in place; and (5) the minimum percentage of share capital thaan extraordinary shareholders meeting is less than or equal to 10 percent, source: LLSV (1998); MARthe value one for market-based systems and zero for bank-based systems, source: DM (2002); DEBT/GNdebt of the private sector and outstanding non-financial bonds to gross national product in 1994, sourratio of the total value of shares traded on the stock exchange divided by the market capitalization in eaverages), source: DM (2002); TAX is the tax rate on undistributed corporate profits used in LLSV (return required in each country on a hypothetical investment project with a post-tax required real rateDevereux et al. (2003); OWN10 proxies the corporate ownership concentration in a country, source: LLS

of return 5 percent estimated byV (1998).

28

French Law =

German Law

French Law = Scandi.

Law

German Law = Scandi.

Law

*** (***)

*** (***)

** (**)

*** (***)

*** (***)

* (*)

* (*)

*** (***)

** (**)

*** (***)

*** (***)

(*)

*** (***)

*** (***)

*** (***)

*** (***)

(***)

*** (***)

** (*)

*** (***)

(*)

*** (**)

*

P/E ratio of a firm and measureslongs to manufacturing / energy /rm is listed on a foreign exchangetage of foreign sales of the firm isthan 49 percent, MGMTOWN isownership in the firm is less thanm and proxies the agency costs of

fference in means and Wilcoxon test for ians ( in parentheses)

ystem Countriesariable ranges from 0 to 4 and is

s consent or minimum dividends,reorganization petition has been

t result from the disposition of thee resolution of the reorganization,

in the firm. This variable rangesers to mail their proxy vote to theeeting; (3) cumulative voting or

t entitles a shareholder to call forKET is a dummy variable that takes

P is the ratio of the sum of bankce: LLSV (1997); TOVER is theach country (based on 1989-19962000); COC is the pre-tax rate of

29

Legal Financial Others

x √ x xMARKET (-0.55**)

x x √COC

(0.41*)x x x

√ x x CRRHT (-0.31*)

x x x

√ x x(Civil vs.

Common-law)

√ x xCRRHT (-0.26*)

nificant at the 0.05 level.nificant at the 0.10 level.

nificant at the 0.01 level.

imes Financing in bad times is a higher concern in countries with - (%SHRTDEBT: -√ Lower quality of legal systems

Concern about minimizing WACC is higher in countries with - (%SHRTDEBT: -0

h Maturity Matching maturity is a higher concern in countries with - (%SHRTDEBT: -

ngs ility

Concern for earnings volatility is higher in countries with - Not sensitive

ial bility

g

C

- (SIZE: 0.31***) -(FRNISSUE: 1.06

- (FRNREV: 0.16**-(MGMTOWN: 0.53*

√ Lower quality of legal systems

Flexibility is valued more in countries with x Lower quality of legal systems, Smaller capital markets

Credit rating is valued more in countries with

Tax advantage of debt is valued more in countries with x Higher corporate tax rates, Higher cost of capital (+ve coeff. but insignificant)

x Lower quality of legal systems

- (FRNREV: 0.27** -(%SHRTDEBT: 1.36*

√ Lower quality of legal systems

-specific variables include: SIZE (a natural log of market capitalization of a firm), P/E (P/E ratio of a firm), INDUSTRY (a dummy variable wtherwise), FRNLST (a dummy variable with one for foreign listed firm and zero otherwise), FRNSALE (the degree of foreign sales with one for sale

etween 25-49, and four for sales greater than 49 percent), MGMTOWN (a dummy variable with zero for managerial ownership less than 5 percenterm debt to total debt of a firm).

Summary of the Cross-Sectional Regressions Results in Panel A and Thei

x Higher corporate tax rates , Higher cost of capital

Table VIII

Significant Country-level variablesMajor

inantsSignificant Firm-spe

variables

Evidence on Country-level variables

√ (x) is (not) consistent with the prediction

irst column lists the major determinants of capital structure, the second column reports the prediction and relation between the factor and the countryicant country level variables, the fourth column summarizes the significant firm-specific variables, and fifth column relates whether the factor suppor

try-specific variables are of three types: (1) Legal variables: Common law (intercept) versus civil law systems, creditors' rights index (CRRHT 1998), discussed in Table VII (Panel A); (2) Financial variables: MARKET is a dummy variable with one for market-based and zero for bank-base the sum of bank debt of the private sector and outstanding non-financial bonds to gross national product in 1994 and is obtained from LLSV (1997k exchange divided by the market capitalization in each country (based on 1989-1996 averages) are obtained from DM (2002); (3) Others: TAX i

), COC is the pre-tax rate of return required in each country on a hypothetical investment with a post-tax required real rate of return 5 percent estimatte ownership concentration in a country compiled in LLSV (1998).

AgencyAsymmetric information

General Trade-off

Global markets

Debt Policyx x √

√ x x x

x √ x √x x x x

Tax x x √ √x x √ x

√ x x x

x x

√ x

√ x √ x

√ x √ x

**Sig*Sig

***Sig

Bad T 0.96*)

.94*)

Matc 1.10**)

EarniVolat

FinancFlexi

Credit Ratin

WAC

***)

) * )

*) )

The Firm ith zero for manufacturing / energy / transportation industry and one o s between 1-10 percent, two for sales between 10-24 percent, 3 for sales b t and one otherwise), and %SHRTDEBT (the percentage of short-

Different Theories and Factors

r Implications

determcific

The f -level variables, the third column summarizes evidence on the signif ts (√) or does not support (x) a theory.

The Coun ) and shareholders' rights index (SHRHT) obtained from LLSV (1997, d systems and is obtained from DM (2002), DEBT/GNP is the ratio of ), and TOVER is the ratio of the total value of shares traded on the stoc s the tax rate on undistributed corporate profits used in LLSV (2000 ed by Devereux et al. (2003), and OWN10 proxies the corpora

Legal Financial Others AgencyAsymmetric information

General Trade-off

Global markets

Equity Policyx √ √ x x x x

DEBT/GNP (1.93**)

OWN10 (-5.05***)

√ x x √ x √ x

x x √ x √ √ xCOC

(0.83**)x x √ x √ √ x

COC (0.88*)

***Significant at the 0.01 level.**Significant at the 0.05 level.*Significant at the 0.10 level.

Under (Over) Valuation of stock

Concern about valuation of stock is higher in countries with - (P/E: 0.03* in individual regression)√ Higher cost of capital

Hi Stock Price Concern about stock price is higher in countries with - (P/E: 0.03*)

Target Debt-Equity Ratio

- (%SHRTDEBT: -1.55*)√ Lower quality of legal systems (Civil vs.

Common-law)

Significant Country-level variables Significant Firm-specific

variables

Different Theories and Factors

EPS Dilution Concern about EPS dilution is higher in countries with - Not sensitive

Maintaining a target ratio is valued more in countries with

√ (x) is (not) consistent with the prediction

√ Higher cost of capital ( in individual regression)

x Lower quality of legal systems

x Higher corporate tax rates, Higher cost of capital

Table VIII (Continued)

Major determinants

Evidence on Country-level variables

30

Figure I. Characteristics of the respondent firms

A: Sales (million euro)

0%

10%

20%

30%

40%

50%

100-499 500-999 1000-4999 >5000<100

D: Price/earnings ratio

20%

25%

30%

C: Industry

0%

5%

10%

15%

20%

Ret

ail a

nd w

hole

sale

Min

ing,

Con

stru

ctio

n

Man

ufac

turin

g

Tran

spor

t./E

nerg

y

Co m

mun

icat

ion/

Med

i

Bank

/Fin

ance

/Insu

ranc

Hig

h te

ch

Ot h

er

E: Other characteristics

75%

100%Widely /

closely held

Utility/non-utility

Paydividends

B: Market capitalization (million euro)

0%

10%

20%

30%

40%

50%

<100 100-499 500-999 1000- 4999 >5000

0%

5%

10%

15%

10-14 15-19 20-24 >25 <10

G: Long term debt ratio (%)

0%

10%

20%

30%

40%

10-19 20-29 40-49 >49 1-9 0 30-39

0%

25%

50%

Yes NoPrivate Yes Public No

F: Other characteristics

0%

20%

40%

60%

80%

100%

OtherCAPMYes Yes No

Multiple class of shares

Use CAPM

No

Target debt ratio

31

Figure I. Characteristics of the respondent firms (followed)

K: Foreign Sales (% of total)

0%

20%

40%

60%

80%

1%-10% 11%-24% 25%-49% >50%

H: Percent that seriously considered issuing...

0%

20%

40%

60%

80%

100%

No Yes Yes No No

Common stock

Convertible debt

Yes

Foreign debt

L: Foreign Listing

0%

20%

40%

60%

US & Europe

EuropeYes US No

List on Foreign Exchanges

Other

Foreign Exchanges of listing

J: Influence of Stakeholders on Financing decisions

0%

25%

50%

75%

100%

Bondholders

Local Govt

Employees

StockholdersGovt

Low High Low High Low HighLow High Low High

I: Approximate cost of equity

0%

10%

20%

30%

40%

50%

>15%12%-15%<9% 9%- 12%

M: Exec. stock ownership

0%

20%

40%

60%

80%

100%

>20%10%-20%<5% 5%- 10%

32