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Corporate Financing Decisions: Survey Evidence from Sri

Lanka

Y.K.Weerakoon Banda

Department of Finance, Faculty of Management Studies and Commerce,

University of Sri Jayewardenepura, Sri Lanka.

weerakon@sjp.ac.lk

professor, Department of Finance

Abstract Purpose- The purpose of this paper is to examine the practice of corporate financing decisions of the firms in Sri Lanka. It focuses on the management characteristics towards firm-specific characteristics. based on a survey of CFOs of large companies listed in the Colombo Stock Exchange. Design/methodology/approach-In this study a survey instrument methodology was employed based on non financing firms listed on the Colombo Stock Market in Sri Lanka. The sample was selected from the top 50 companies in the Lanka Monthly Digest. Findings- The study indicates that the corporate financing decisions in Sri Lanka differ from developed countries especially from the US. The survey findings reveal that agency cost and pecking order hypotheses are not fully understood by the CFOs on their financing practices. The results provide mixed support for the static trade-off theory. The tax advantage of debt is perceived by CFOs in their practices than bankruptcy cost. There is no significance association between management characteristics and the firm-specific characteristics of corporate financing. In view of financing pattern, they depend on local debt market observing financial flexibility rather than issuing foreign debt. Between debt and equity choices, CFOs are more concerned about equity issues and make complementary decisions observing earnings per share dilution and price appreciation in recent past. Research limitations/implication-The study is restricted to Sri Lankan environment and the sample size used is relatively small. Practical implication- This study offers insights for corporate financing decision makers in relation to static trade-off theory to have full impact on firm value like U.S.A and Europe countries. The CFOs of listed companies in Sri Lanka will be better informed as a direct consequence of this research referring static trade-off theory that are in line with corporate financing decisions.

Originality/value- This is the first to study in Sri Lanka that examines the practice on corporate financing decisions using a survey method that indicates higher internal consistency reliability of survey questionnaire in terms corporate financing.

Keywords: Corporate Financing, Capital Structure, CFO, Management characteristic, Sri Lanka, Survey Paper Types Research paper

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1. Introduction

Corporate finance researchers have devoted considerable effort to investigating determinants of capital structure and significant progress has been made during last decade together with financial contracting theory (Barclay and Smith, 1995; Graham et al., 1998; Mehran et al., 1999). However, this theory examined the firm characteristics and their effect on demand for capital. It primarily considered tax benefit of financing, risks and cost involved in financing, agency conflict arising from corporate financing, and information asymmetry.

There are some supply side effects as there is channel of intermediation between ultimate suppliers of capital and corporate users of capital. The most significant channels are banking sector, private and public credit markets, and equity market. The key drivers of supply effects are intermediation, corporate opportunism and corporate investor behavior. Although, less attention has been given to effects of supply of funds and the management characteristics, empirical support for determining factors of demand for capital has been extensively covered. So this paper focuses on examining the management characteristics and practices of corporate financing in Sri Lanka.

The rest of the paper proceeds as follows: In the second section, it deals with literature review. The next section discusses some aspects in relation corporate financing decisions, Pecking order financing and trade-off consideration. The fourth section it employs survey design and analysis. The last section concludes the findings.

2. Literature Review

Capital structure theories provide directions for some decision horizons in corporate finance. These are more or less important empirically. The corporate financing considers basically debt and equity decisions involving various determining factors. No theoretical support provides ascertaining the appropriate amount of funds to be employed in a firm selecting appropriate projects, raising funds on the most favorable terms possible and finally managing working capital such as inventory and accounts receivable. However, the goals of corporate finance can be achieved only when the corporate investment is financed appropriately. The company should therefore identify an optimal mix of financing i.e. the one which results in a maximum value or a minimum cost.

2.1 Pecking order financing and trade-off consideration

Modigliani and Miller (1958) and Miller (1977), the prominent scholar of the capital structure theory, also accept in their paper that after incorporating corporate taxes into theory that the firm has higher value though unlevered firm taking the benefits of tax shield on interest. Miller (1977) extended the theory incorporating personal taxes and in equilibrium the value of the firm is independent.

The sources of finance are manly comprised of a combination of debt and equity financing. A project that is financed through debt results in a liability and a higher cost of equity than that of cost of debt. The equity financing may result in an increased hurdle rate which will offset any reduction in the cash flow risk. The management of the company must match the financing mix to the asset that is being financed. Pecking order financing (Myers and Majluf, 1984; Myers 1984), as to how the firms make their financing hierarchchy, suggests avoiding external financing if they have an option of internal financing. They also avoid equity financing if they have an option of debt financing at lower interest rates. When raising debt capital, appropriate amount of debt depends on corporate debt capacity (Donaldson, 1962) and firm-specific determinants (Titman and Wessels, 1988; Srivastava and Ankita 2012; Ramzi, and Tarazi, 2013). Trade-off hypothesis, for examples, considers

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the tax benefits of debt with the Bankruptcy cost of debt in corporate financing decisions (Clifford, et al, 1979); financial Distress on Trade Credit (Molina, et al, 2012).

In reviewing capital structure theories there are some important concepts involved in corporate financing. Before ahead surveying existing practices, relevant measures and abstract concepts are reviewed in order to identify dimensions of the survey questions.

2.2 Abstract Concepts and Measures

Leverage: Singh (1992, 1995) confirms that firms in Less Developed Countries’ (LDC) are not as highly geared as firms in developed countries. In contrast, Atkin and Glen (1992) indicate that firms in LDCs are highly geared than developed countries. Interestingly both researchers have used the same IFC database. According to findings of Titman and Wessels (1998), firms that can potentially impose high costs on their customers, workers and suppliers in the event of liquidation, tend to choose lower debt ratios. Rajan and Zinagles (1995) conclude that the mean leverage of US firms is 31% while in Japan it is 35%. Mohomed (1995) finds that the mean debt ratios of Malaysian firms are 44.38%. In an analysis done by Tong Liu (1999) the debt ratio has been found to be close to 3.76% for listed companies in China. Laurance Booth et al., (2000) argue that the book debt ratio is around 30%. In comparison to international findings the typical Sri Lankan listed firms are less leveraged (Samarakoon, 1999; Weerakoon, 2005). Hence, target leverage of corporate firms in Sri Lanka is also less important in financing decisions.

Internal funds and Leverage: Singh and Hamid (1992) conclude that there is a negative relationship between profitability and capital gearing in India. This is in line with the pecking order hypothesis that profitable firms use less debt and more internal funds, hence the negative relationship. Agreeing with this theory, Wald (1999) also finds that profitable firms have lower debt to asset ratios. This is because firms prefer to finance with internal funds rather than debt. Johnson (1986) finds a positive relationship, if the market for corporate control is effective and forces firms to commit to paying cash by levering up. If it is ineffective however, managers of profitable firms prefer to avoid the disciplinary role of debt, which would lead to a negative correlation between profitability and debt.

Rajan and Zingales (1995) find that profitability is negatively correlated with leverage. They state that in the short-run, dividends and investments are fixed, and if debt finance is the dominant mode of external financing, then changes in profitability will be negatively correlated with the changes in leverage. The negative influence of profitability on leverage should become stronger as firm size increases. This has been proved to be the case in US. However, in contrast, Mohomed and Mohamed (1995) find that there is a positive relationship between leverage and operational performance. Research work by Demirguc-kunt and Maximovic (1994) find the proxies for profitability negatively related to leverage in ten developing countries. Tong Liu (1999) finds a significant negative relationship between profitability and leverage in a research of selected Chinese firms. Thus, these results point to a strong negative relationship between profitability and debt.

Growth: Myers (1990) finds that growth options are not financed using long term debt. Singh (1995) finds that in India, approximately 40% of a company’s growth options are finance through long-term debt and therefore there exists a positive relationship between growth and debt. Singh and Hamid (1992) find that most of the fast growing East Asian economies finance growth through debt (gearing ratio exceeds 50%). Margret Foggarty (1998) finds that future growth is negatively related to long term debt. Demirguc-Kunt and Maximovic (1994) emphasize that the relationship between the rate of growth and leverage is weak but consistent with the predictions of Agency Theory. Tong Liu (1999) finds that in

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China leverage and growth are positively related. According to Tong Liu’s findings, high growth firms happen to be utility firms. These firms get more support from the state under the Chinese government’s current policies. Hence they may have more access to funds, especially long term debt from banks. Rajan and Zingales (1995) find that there is a negative relationship between leverage and growth. Further, they indicate that highly levered firms are more likely to pass up profitable investment opportunities. Therefore, firms expecting high future growth use a greater amount of equity finance. Allen and Mizano (1989) indicate that the effects of growth are not certain and therefore they excluded the growth variable from their subsequent analysis. Margret Foggarty (1998) find that the sample of Latin American firms finance relatively little of its growth, from international sources, and even less from debt and relies primarily on equity issues.

Financing for Current Assets: Companies use different approaches to finance current assets. Some of the companies can finance some of its short-term assets (including permanent current assets) with permanent funds. In contrast, another company could follow a policy of having almost no working capital, meaning that it finances all of its short-term assets with temporary funds or labeled as current liabilities (Omolumo, 1997). Regardless of the degree to which a company is subject, seasonal or cyclical fluctuations, all companies need some minimum amount of current assets.

Research on investment and financing policy has been carried out by a number of researchers (Afza, Nazir, 2007 and 2008; Weinraub and Sue, 1998; Salawu, 2006) and with the support of available literature and relevant theories of Working Capital Management (WCM), degree of aggressiveness or conservativeness is measured by Total Current Assets to Total Assets Ratio (Investment Policy) and Total Current Liabilities to Total Assets Ratio (Financing Policy).

Some of researchers (Weinraub and Visscher, 1998; Rehman, 2006; Soenen, 1993; Jose et al., 1996; Gardner et al., 1986) find that short term financing policy (aggressive) increases the firm profitability of the firms, while decreasing the level of Economic Value Added (EVA) than moderate policy. Saman Bandara and Weerakoon (2009) also find that aggressive investment policy yields a relatively lower level of EVA in Sri Lankan firms. It further concludes that, if any firm operating with aggressive investment policy together with aggressive financing policy, it decreases the EVA relatively to the firms that operate with moderate policy.

Liquidity and Profitability: The matching maturity principle helps maintain liquidity, i.e., maintaining sufficient cash for operations, because it requires companies to match the terms of assets and liabilities. If a company is seeking funds for a new manufacturing plant, it should be financed with long-term financing. If it uses a short-term loan, the cash flow from the new plant might not materialize before the loan matures and repayment is required in full. The company could then be forced to come up with other sources of financing, renegotiate the loan at possibly higher interest rates or possibly default.

This matching principle is important for profitability as well because interest expenses flow through to net income. Short-term debt is usually less expensive than long-term debt, while short-term assets are normally less profitable than long-term assets. Therefore, if a company finances a short-term project with a long-term loan, it is using expensive debt to invest in unprofitable assets (overinvestment). This increases interest expenses and reduces profitability.

3. Survey Method

A number of surveys have been carried out based on corporate finance related issues

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(Graham and Harvey, 2001 and 2002; Bancel and Mittoo, n.d; Ibrahima et al., n.d) in different financial environments. The issues of practice that have been analyzed using secondary data relate to empirical work (Buferna et al., 2005; Sheikh and Wang, 2011; Khrawish and Khraiwesh, 2010; Mefteh and Oliver, n.d). Graham and Harvey point out the influence of management and firm characteristics in corporate financing decisions referring to capital structure theories. Similar to Graham and Harvey, there are several surveys conducted by some researchers (Bancel and Mittoo, n.d; Ibrahima et al., n.d) in developed and developing countries to understand the practice of capital structure of the firm.

In attempting to understand the corporate capital structure decisions of the Sri Lankan firms, this study is very important as this is the first to study the practice of corporate financing decision using survey method.

4 Results of the study Surveys were administered to a total of 37 from CFOs of large 50 companies, classified

by Lanka Monthly Digest and, listed in the Colombo Stock Exchange for the period

2010/1011.1 Among the studies surveying capital structure practices, response rate was

relatively very low, but in this study response rate is very high, 64%.2 The respondents

were asked four categories of questions, namely firm's choice between short-and long-term debt, decisions about issuing foreign debt, decisions about issuing common stocks, and choosing the appropriate amount of debt for the firm. We asked CFOs different questions and put them on a scale of 0 (not important) to 5 (very important) in deciding issuing

common stocks.3

In addition to survey analysis, consistency and reliability measure of relevant category of

survey questions is established by testing for Cronbach’s Alpha.4 As in all the table values

for Cronbach’s Alpha coefficients are more than 0.7, it indicates the higher internal consistency reliability of survey questionnaire in terms of common stock, short-and long-term debt, foreign debt, and debt policy.

4.1 Common Stock

The survey results are summarized in Table 2 in Appendix B and their concerns are presented in Figure 1.

Table 1 in Appendix C shows that the questions relevant to common stock issue are positively correlated to one another and, hence, Cronbach’s Alpha coefficients are from 0.982 to 0.985 and the overall value is 0.984 i.e., the higher internal consistency reliability of survey questionnaire in terms of common stock.

Target leverage: Survey results summarized in Figure 1 indicate said that they maintain target leverage ratiorespondents who maintain target debt-equity ratio are young (mean rating of 3.57) male (3.5) when they have MBA (3.4). The rest of the respondentshave target leverage ratio though it is the major factor in ca

Increase in stock price: The second important factor is that corporate managers concerned about “window of opportunity” that arises due to accordingly they issue stock. Among the 28.6% firmequity capital in a situation where the market condition is favorable.the Table 2 in Appendix B. So the timing of equity issue is important factor in Sri Lankathough it indicates moderately important inconsistent with Loughran and Ritter (1995); Lucas and McDonald (1990).

Earnings dilution: Among the 25% of CEOsshares during the sample period that earnings2.78. Female matured executives with MBA (3.0, 3.0, than the others. EPS dilution is less important when executives are young (2.71) and male (2.75). In general, 32 CFOs are preferred issuing equity and this is confirmed through the dilution effect also.

Internally generated funds: Among 21.4% of whether internal funds (profit) sufficient to invest in new projects. Most of matured female executives with MBA (mean rating of 3, 2.80, and 3 respectively) are of this view.

Employee share option (ESOP): Survey result indicates that evidence that ESOP is important factor when they issue equity capital. The mean rate is and most of the CEOs are male and MBA holders’

Maintaining a target debt-to-equity ratio

If our stock price has recently risen, the

Earnings per share dilution

Whether our recent profits have

Providing shares to employee

Diluting the holdings of certain

The amount by which our stock is

The capital gains tax rates faced by our

Stock is our "least risky" source of funds

Inability to obtain funds using debt,

Common stock is our cheapest source of

Issuing stock gives investors a better

Using a similar amount of equity as is

Important or very important concerns in issuing

common stocks

% of CFOs identifying factors as important or very important

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urvey results summarized in Figure 1 indicate 28.6% of the respondents

said that they maintain target leverage ratio (mean rating of 3.33). The most of the equity ratio are young (mean rating of 3.57) male

(3.5) when they have MBA (3.4). The rest of the respondents (71.4%) mentioned they do not though it is the major factor in capital structure decisions.

The second important factor is that corporate managers are “window of opportunity” that arises due to recent price increases and

Among the 28.6% firms that seriously considered raising equity capital in a situation where the market condition is favorable. The mean rate is 2.89 in

So the timing of equity issue is important factor in Sri Lanka though it indicates moderately important in capital structure decisions. This evidence is consistent with Loughran and Ritter (1995); Lucas and McDonald (1990).

CEOs seriously considered when they issue common earnings dilution factor is important. The mean rate is

Female matured executives with MBA (3.0, 3.0, and 2.8 respectively) hold this belief than the others. EPS dilution is less important when executives are young (2.71) and male

eferred issuing equity and this is confirmed through the

Among 21.4% of CEOs answered to the question relating whether internal funds (profit) sufficient to invest in new projects. Most of matured female executives with MBA (mean rating of 3, 2.80, and 3 respectively) are of this view.

Survey result indicates that 17.5% of the CEOs provide important factor when they issue equity capital. The mean rate is 2.44

MBA holders’ (mean of 2.5 and 3.0 respectively).

0%

5%

10

%

15

%

20

%

25

%

30

%

equity ratio

If our stock price has recently risen, the …

Earnings per share dilution

Whether our recent profits have …

Providing shares to employee …

Diluting the holdings of certain …

The amount by which our stock is …

The capital gains tax rates faced by our …

Stock is our "least risky" source of funds

Inability to obtain funds using debt, …

Common stock is our cheapest source of …

Issuing stock gives investors a better …

Using a similar amount of equity as is …

Figure - 1

Important or very important concerns in issuing

common stocks

% of CFOs identifying factors as

Under-or over-investment: Among the CEOs issuing equity (mean average is 2.22) by most of nondilution effect of share issues. Finally in viewing the responses to the last three aspects asking whether stock is least risky and cheapest funds using debt, convertible debt results indicate the same, 8% (indicates common stock is not considered as che

We find very little evidence that firms consider capital gain tax rates relative to dividend tax faced by investors when deciding equity issue

4.2 Short-and long-term debt in capital structure changes

The survey results are summarized in Table 3 in presented in Figure 2.

Table 2 in Appendix C shows Cronbalong-term related questions are positively correlated to one another. As all coefficients are from 0.797 to 0.839, it indicates the higher internal consistency reliabilityquestions. Hence, the overall measure of Alpha coefficient is 0.832.

Maturity of assets and liability: In attempt to understand term debt and their level of maturity i.e., shortterm financing and long-term assets with longof the CFOs responses were, they consider the assets structure andfinancing decisions.

we issue short term when

matching the maturity of our

we issue short term when we

we borrow short term so that

we expect our credit rating to

borrowing short term reduces

we issue long term debt to

Figure

Important or very important concerns in Firm's choice

between short-and long

Series1% of CFOs identifying factors

as important or very ....

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Among the CEOs 14.3% considers under-investment when by most of non-MBA holders. This is consistent with

Finally in viewing the responses to the last three aspects and cheapest source of funds, and inability to obtain

, convertible debt results indicate the same, 8% (mean of 1.56). This indicates common stock is not considered as cheapest source of funds.

We find very little evidence that firms consider capital gain tax rates relative to dividend tax quity issue (rating of 7.10% in the Figure).

term debt in capital structure changes

Table 3 in Appendix B and their concerns are

shows Cronbach’s Alpha coefficients that indicate short and questions are positively correlated to one another. As all coefficients are

, it indicates the higher internal consistency reliability among the verall measure of Alpha coefficient is 0.832.

In attempt to understand the practice that short-and long-short-term assets should be financed with short-

term assets with long-term financing, Figure 2 indicates that 64.3% of the CFOs responses were, they consider the assets structure and liability structure in their

e 0.00% 20.00% 40.00% 60.00% 80.00%

we issue short term when …

matching the maturity of our …

we issue short term when we …

we borrow short term so that …

we expect our credit rating to …

borrowing short term reduces …

we issue long term debt to …

Figure -2

Important or very important concerns in Firm's choice

and long-term debt

Timing market interest rates: Preference for the level of interest rates, wheterm interest rates are low compared to long term rates, is issuing debt. For example, the survey provides strong evidence that concerned about times interest rates when issuing debt. Further, as shown in Figure 2of CFOs are concerned about short term debtthen waited expecting for long term market interest rates to decline. concerned about long term debt in refinancing result in improvement in product quality in the market as well

Anticipating improvement in credit rating

CFOs are concerned about credit quality and resulting optimal debt maturity. If firms know their high credit quality, but currently assign low ratings, they tend to use short term debt expecting their rating to improve in near future. This is consistent with evidence research (Flennery, 1986; Kale and Noe, 1990).

Results provide little evidence that borrowing shortbe captured more fully by shareholders, rather than committing to pay long term profits as interest to debt holders (rating of 10.7%). Also, the Figure 2 provides little evidence that borrowing short term reduces the chance that the firm will want to take on risky project (rating of 7.1%).

4.3 Foreign Debt and changes in capital structure

The survey results are summarized in Table 4 in presented in Figure 3.

Table 3 in Appendix C shows Cronbach’s Alpha coefficients that indicate foreign debt

related questions are positively correlated to one another. As all coefficients are from to 0.97, it indicates the higher internal consistency reliability among the questiothe overall measure of Alpha coefficient is 0.958

Among SEOs, 17.90% responses were they are keen on issuing foreign debt when the interest rate on debt is low or declining. They delay issuing debt because of transactions

Favorable tax treatment

Keeping the "source of funds"

Providing a "natural hedge"

Foreign regulatios require us

Foreign interest rates may be

Figure

Important or very important concerns in decision about

issuing foreign debt

Series1% of CFOs identifying factors as

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Preference for the level of interest rates, whether the short to long term rates, is very important factor when provides strong evidence that 60.7% of CFOs are

interest rates when issuing debt. Further, as shown in Figure 2, 46.4% short term debt issue, and if the market interest rate is high

for long term market interest rates to decline. But 42.9% of CFOs are in refinancing in a bad time periods avoiding risk. This will

in improvement in product quality in the market as well.5

Anticipating improvement in credit rating: Further survey results indicate that 17.9% of CFOs are concerned about credit quality and resulting optimal debt maturity. If firms know

quality, but currently assign low ratings, they tend to use short term debt expecting their rating to improve in near future. This is consistent with evidence of previous research (Flennery, 1986; Kale and Noe, 1990).

at borrowing short-term and returns from new projects can be captured more fully by shareholders, rather than committing to pay long term profits as interest to debt holders (rating of 10.7%). Also, the Figure 2 provides little evidence that

t term reduces the chance that the firm will want to take on risky project

Foreign Debt and changes in capital structure

Table 4 in Appendix B and their concerns are

in Appendix C shows Cronbach’s Alpha coefficients that indicate foreign debt related questions are positively correlated to one another. As all coefficients are from 0.935

, it indicates the higher internal consistency reliability among the questions. Hence, 0.958.

responses were they are keen on issuing foreign debt when the They delay issuing debt because of transactions

0.00% 5.00% 10.00% 15.00% 20.00%

Favorable tax treatment …

Keeping the "source of funds" …

Providing a "natural hedge"

Foreign regulatios require us …

Foreign interest rates may be …

Figure - 3

Important or very important concerns in decision about

issuing foreign debt

costs and fees. Second important concern in foreign debt issue is tax treatment relative to Sri Lanka (rating of 14.3%). The next concern is providing a "natural hedge" (e.g. if the foreign currency devalues, we are not obligated to pay interest in US$).indicate the same (3.6%) rating, one indicating when there are SEOs willingness to issue foreign debt, and the second indicating at minimum level source of funds equal to the use of funds.

4.4 Debt policy and Appropriate Amo

The survey results are summarized in Table 5 in Appendix B and their concerns are presented in Figure 4.

Table 4 in Appendix C includes Cronbach’s Alpha coefficients for the questions focusing on the firm’s debt capital. All coefficients are fmeasure is 0.892, which indicates internal consistency reliability of the questions asthe CFOs.

According to Figure 4, CFOs are considered as important or very important on the volatility of earnings and cash flows, the tax advantage of interest deductibility, and the transactions costs and fees for issuing debt which show the frequency of 78.60%, 64.30%, and 57.10% respectively. The mean value ratings of these factors are 3.04, 2.82, and 2.57, respectively. These provide evidence that the volatility of earnings and cash flows are an important factor in choosing appropriate amount of debt for the firms while the tax advantage on debt interest, and the transactions costs and floatation cost of debmoderately important. The credit rating is also moderately important or very important when issuing debt (rating of 53.60% of CFOs and

Further survey results indicate that CFOs ratings on financial

0%

The volatility of our earnings and …

The tax advantage of interest …

The transactions costs and fees for …

Our credit rating (as assigned by …

Financial flexibility (we restrict debt …

We limit debt so our …

The potential costs of bakruptcy, …

The debt levels of other firms in our …

We restrict our borrowing so that …

We try to have enough debt that we …

If we issue debt our competitors …

The personal tax cost our investors …

To ensure that upper management …

A high debt ratio helps us bargain for …

Figure 4: Important and very importat concern in Debt

Policy Factors

% of CFOs identifying factors as important or very …

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nd important concern in foreign debt issue is tax treatment relative to Sri Lanka (rating of 14.3%). The next concern is providing a "natural hedge" (e.g. if the foreign currency devalues, we are not obligated to pay interest in US$). The next two factors

dicating when there are favorable foreign regulations SEOs willingness to issue foreign debt, and the second indicating at minimum level source

ropriate Amount of Debt

The survey results are summarized in Table 5 in Appendix B and their concerns are

includes Cronbach’s Alpha coefficients for the questions focusing on the firm’s debt capital. All coefficients are from 0.874 to 0.902 and the overall

consistency reliability of the questions asked from

CFOs are considered as important or very important on the flows, the tax advantage of interest deductibility, and the

transactions costs and fees for issuing debt which show the frequency of 78.60%, 64.30%, and 57.10% respectively. The mean value ratings of these factors are 3.04, 2.82,

espectively. These provide evidence that the volatility of earnings and cash flows are an important factor in choosing appropriate amount of debt for the firms while the tax advantage on debt interest, and the transactions costs and floatation cost of debt are also moderately important. The credit rating is also moderately important or very important when issuing debt (rating of 53.60% of CFOs and the mean value of the factor is mean 2.04).

Further survey results indicate that CFOs ratings on financial flexibility (mean value

0%

10

%

20

%

30

%

40

%

50

%

60

%

70

%

80

%

Figure 4: Important and very importat concern in Debt

Policy Factors

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of 2.07), the potential costs of bankruptcy, near-bankruptcy or financial distress (mean vale of 1.75), and the personal tax cost of investors face when they receive interest income (mean value of 1.32) are rated as fairly important and not important in choosing appropriate amount of debt decisions, respectively, which are also recorded lower level of frequency considering important or very important factors.

5. Conclusions

This research finds no significant association that the CFOs are far away from the guidelines or theory in their corporate financing decisions of listed companies in Sri Lanka. The results indicate that the corporate capital structure decisions differ in Sri Lanka from developed countries especially in the US.

The survey findings of this study contribute broadly to the corporate financing decisions. It reveals the importance of incorporating the agency costs and packing order model as the points are not fully understood by the CFOs on their financing practices. The static trade-off theory provides mixed support, the tax advantage of debt is perceived by CFOs in their practices than bankruptcy cost. It is generally accepted that the survey finds no significant association between management and firm characteristics and pecking order theory in corporate financing decisions. In view of capital structure pattern, they depend on local debt market rather than issuing foreign debt. In reviewing between the corporate equity and debt, CFOs are concerned about equity issues and when they issue equity more concern about earnings per share dilution and price appreciation in recent past. When the firms issue debt they are much concerned about financial flexibility.

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Corresponding author

Weerakoon Banda can be contacted at: weerakon@sjp.ac.lk or +94715341914

13

Appendix A: Response rate of prior survey research on capital structure determinants

Author/s Year Respondents Response rate

Donaldson

Scott & Jomsen

Pineger & Wilbricht

Graham & Harvey

Allen

Bancel & Mitto

1961

1989

1989

2001

1999

2004

25 large US Companies

CFO’s of 212 of Fortune 1000 firms

CFO’s of 176 of Fortune 500 firms

CFO’s of 98 Fortune 500 firms

392 of Fortune 500 firms

-400 firms

-4400 firms

132 Australia

67 Large UK

53 Japan

87 firms across 16 European countries

Na

21%

35%

21%

9%

24%

13%

10%

12%

14

Appendix - B

Table 1: Correlation structure between the survey data

Tenure Age Education Gender Race Industry Target

debt

ratio

Growt

h

Credit

ratings

Leverag

e

Size

Tenure

Age .440**

Education 0.312* 0.272

Gender 0.101 0.037 0.091

Race(sl to others) -0.181 -0.219 0.091 0.253

Industry -0.036 0.032 0.029 0.141 0.141

Target debt ratio(y/n) -0.026 -0.141 0.096 -0.017 -0.017 -0.122

Growth .427** 0.251 0.083 -0.067 -0.3 0.354* -0.043

Credit ratings(y/n) -0.101 -0.183 -0.372** -0.6*** -0.067 -0.236 -0.258 0.01

Leverage(low to high) 0.101 0.292 0.322* -0.12 -0.12 0.141 .465** -0.067 -.6***

Size(large to small) 0.369** 0.304 0.179 -0.067 -0.067 0.079 -0.143 0.222 0.111 -0.067

Paying dividends(y/n) 0.101 0.292 0.091 -0.12 0.253 0.141 -0.258 -0.067 0.2 -0.12 -

0.067

*** significance at 1% level ** significance at 5% level * significance at 10% level

15

Appendix B…….

Table 2:Factors affecting the firm's decisions about issuing common stock

Question Mean

Imp or very

imp %

1 maintaining a target debt-to-equity ratio 3.33 28.60%

2 if our stock price has recently risen, the price at which we can issue is "high" 2.89 28.60%

3 earnings per share dilution 2.78 25.00%

4 whether our recent profits have sufficient to fund our activities 2.67 21.40%

5 diluting the holdings of certain shareholders 2.56 14.30%

6 providing shares to employee bonus/stock option plans 2.44 17.90%

7 the capital gains tax rates faced by our investors (relative to tax on dividends) 2.22 7.10%

8 the amount by which our stock is undervalued or overvalued by the market 2.22 14.30%

9 stock is our "least risky" source of funds 2.00 7.10%

10 inability to obtain funds using debt, convertibles, or other sources 1.67 7.10%

11 using a similar amount of equity as is used by other firms in our industry 1.56 0.00%

12 common stock is our cheapest source of funds 1.56 7.10%

13 issuing stock gives investors a better impression of our firm's prospects than using debt 1.33 7.10%

Table 3:Factors affecting the firm's choice between short-and long-term debt

Question Mean

Imp or

very

imp %

1 we issue short term when short term interest rates are low compared to long term rates 2.54 60.70

2 matching the maturity of our debt with the life of our assets 2.32 64.30

3 we issue short term when we are waiting for long term market interest rate to decline 2.07 46.40

4 we issue long term debt to minimize the risk of having to refinance in "bad times" 1.93 42.90

5 we borrow short term so that returns from new projects can be captured more fully by shareholders, rather than committing to pay long term profits as interest to debt holders 1.36 10.70

6 we expect our credit rating to improve, so we borrow short term until it does 1.21 17.90

7 borrowing short term reduces the chance that our firm will want to take on risky project 0.79 7.10

16

Appendix B……

Table 4:Factors affecting firm’s decisions about issuing foreign debt

Question Mean

Imp

or

very

imp %

1 favorable tax treatment relative to the Sri Lanka (e.g. different corporate tax rates) 3.6 14.30

2 foreign interest rates may be lower than domestic interest rates 3.2 17.90

3 providing a "natural hedge" (e.g. if the foreign currency devalues, we are not obligated to pay interest in US$) 3 10.70

4 keeping the "source of funds" close to the "use of funds" 2 3.60

5 foreign regulations require us to issue debt abroad 1.4 3.60

Table 5:Debt Policy Factors

Question Mean

Imp or

very

imp %

1 the volatility of earnings and cash flows 3.04 78.60%

2 the tax advantage of interest deductibility 2.82 64.30%

3 the transactions costs and fees for issuing debt 2.57 57.10%

4 financial flexibility (we restrict debt so we have enough internal funds available to pursue new projects when they come along) 2.07 39.30%

5 our credit rating (as assigned by rating agencies) 2.04 53.60%

6 the potential costs of bankruptcy, near-bankruptcy, or financial distress 1.75 28.60%

7 we limit debt so our customers/suppliers are not worried about our firm going out of business 1.57 32.10%

8 the personal tax cost our investors face when they receive interest income 1.32 10.70%

9 the debt levels of other firms in our industry 1.29 21.40%

10 we try to have enough debt that we are not an attractive takeover target 1.25 14.30%

11 we restrict our borrowing so that profits from new/future projects can be captured fully by shareholders and do not have to be paid out as interest to debt holders 1.21 21.40%

12 if we issue debt our competitors know that we are very unlikely to reduce our output 0.96 14.30%

13 to ensure that upper management works hard and efficiently, we issue sufficient debt to make sure that a large portion of our cash flow is committed to interest payment 0.57 3.60%

14 a high debt ratio helps bargaining for concessions from employees 0.5 3.60%

17

Appendix - C

Table - 1

Reliability Statistics: Common Stocks

Cronbach's Alpha: 0.984 No of items : 13

Item-Total Statistics

Scale Mean if Item Deleted

Scale Variance if Item Deleted

Corrected Item-Total Correlation

Cronbach's Alpha if Item Deleted

Q7.1 8.78 163.487 .971 .982

Q7.2 9.07 173.379 .942 .982

Q7.3 8.93 169.456 .903 .983

Q7.4 9.22 178.256 .806 .984

Q7.5 8.63 157.088 .977 .982

Q7.6 9.22 179.179 .949 .983

Q7.7 8.85 166.516 .945 .982

Q7.8 9.30 181.755 .776 .985

Q7.9 9.19 176.926 .862 .984

Q7.10 8.89 166.410 .964 .982

Q7.11 9.00 171.769 .888 .983

Q7.12 9.00 171.615 .954 .982

Q7.13 8.81 164.695 .967 .982

Table - 2 Reliability Statistics: Short-and Long-term debt

Cronbach's Alpha: 0.832 No of items: 7

Item-Total Statistics

Scale Mean if Item

Deleted Scale Variance if Item Deleted

Corrected Item-Total

Correlation Cronbach's Alpha

if Item Deleted

Q1.1 9.6786 22.448 0.654 0.797

Q1.2 9.8929 23.803 0.596 0.807

Q1.3 10.1429 21.905 0.676 0.793

Q1.4 10.8571 24.127 0.584 0.809

Q1.5 11.0000 24.000 0.520 0.819

Q1.6 11.4286 26.550 0.365 0.839

Q1.7 10.2857 21.397 0.661 0.795

18

Appendix C……

Table - 3

Reliability Statistics: Foreign Debt

Cronbach’s Alpha: 0.958 No of items: 05

Scale Mean if Item Deleted

Scale Variance if Item Deleted

Corrected Item-Total Correlation

Cronbach's Alpha if Item

Deleted

Q2.1 1.71 14.582 .987 .935

Q2.2 2.00 19.778 .968 .945

Q2.3 1.82 16.819 .914 .943

Q2.4 2.11 21.581 .777 .970

Q2.5 1.79 16.397 .940 .939

Table - 4

Reliability Statistics: Debt Policy Factors

Cronbach’s Alpha: 0.892 No of items: 14

Item-Total Statistics

Scale Mean if Item Deleted

Scale Variance if Item Deleted

Corrected Item-Total Correlation

Cronbach's Alpha if Item Deleted

Q6.1 20.1429 93.238 .525 .887

Q6.2 21.2143 85.508 .757 .875

Q6.3 21.6786 89.485 .755 .876

Q6.4 20.9286 88.884 .682 .879

Q6.5 20.3929 87.951 .671 .880

Q6.6 21.6429 89.201 .822 .874

Q6.7 20.8929 89.433 .687 .879

Q6.8 19.9286 100.513 .224 .899

Q6.9 21.3929 93.136 .560 .885

Q6.10 21.7143 90.804 .719 .878

Q6.11 22.0000 94.296 .521 .887

Q6.12 22.4643 97.517 .586 .886

Q6.13 22.3929 98.618 .419 .890

Q6.14 21.7500 100.194 .196 .902

19

1 This work is partially based on survey data from CFOs of large companies in Sri Lanka. I

thank Mohamed Rooly for excellent research assistance provided in preparing survey questionnaire and gathering data from the CFOs. 2 See Appendix A for response rate of other capital structure surveys in US and other

markets. 3 See Appendix B for survey questions, their results for Likert scale and mean values, and

the correlation structure between demographic and other characteristics. Survey questions are more or less similar to the study carried out by Graham and Harvey (2002) 4 See Appendix C for Cronbach’s Alpha coefficients of survey questions which were based

on a five point Likert scale. 5 When the market interest rate lowers, real interest rates tend to decrease as well. The ability to borrow money at more attractive rates stimulates investment in durable consumer goods, such as rational necessities such as buildings and capital equipment for businesses. tend to shift investor preference away from bonds and into stock