Financial Operation Within Tax-Exempt Country Proposal

Overview of the Research

This research will investigate factors that determine the capital financing structure of firms within a tax-exempt country, Kuwait. I am informed by my passion to progress my career in the field to expand my knowledge base while contributing to the development of literature, theory, and practice.

This research will add interesting insights to the existing literature on how tax-exempt companies, regardless of the lack of debt incentives, continue to prefer debt financing to internal sources of capital. The research attempts to fill the literature gaps, using theories of capital structure, and provide significant reasons why firms in tax-exempt countries, especially the GCC countries, tend to use debt and equity financing.

Although several studies have focused on this topic, there are still no tangible or conclusive findings that can be used to generalize this scenario.

The reason why I have chosen this research topic is that the paper will be instrumental in contributing toward the development of literature and providing insights to future researchers in the field of business finance. Since the MBS focuses on issues that expand the knowledge base of scholars and answer some of the questions that remain unanswered, my research fits well in this endeavor since it seeks to investigate the decision models of firms operating in GCC countries. Since little research has been compiled to examine these companies, my paper will be significant in this respect.

The findings of this research will help company executives and stakeholders in companies to understand the decision models that inform a firm’s capital structure financing decision. The paper will also confirm the findings of previous studies while finding gaps in some of the studies that have been completed. Therefore, I intend to have a coherent analysis of the firm-specific and sector factors that influence debt financing decisions in GCC countries, especially Kuwait.

Positioning of the Research

While the capital structure has been a popular topic on which many studies have focused, there is no consensus on absolute factors that drive capital structure decisions among companies. Following many studies on the subject, a large theoretical literature has evolved, leading to the development of numerous theories, to explain how decisions on capital structure are made. These theories have pointed to several factors to explain the capital structure of tax-exempt organizations.

The controversy that has emerged concerning the testability and validity of these theoretical models and how they can be used to determine companies’ capital structure. Since some of these theories are difficult to test, it remains difficult to arrive at firm conclusions. Some studies have found that the trade-off theory fails to address the key issues surrounding this topic, concluding that the pecking order theory could offer a more affirmative and explanatory insight.

Some researchers have found no reasons to reject or contend with both the pecking order model and the trade-off theory¹. These studies uphold that while both theories offer informative knowledge about the behavior of corporations in terms of formulating capital structure decisions, they do not lend themselves to explaining the determinants of this endeavor. While there is a consensus on previous literature, which indicates that companies tend to set target levels of their debts, there is no clear agreement on which determinants help companies to reach their optimal targets.

The other gap in the current literature is that many studies that have sought to delve into this line of research have focused on developed or advanced economies. This means that the test results obtained cannot help to explain the capital structure of companies in tax-exempt countries that still developing.

Another focus of the research is that the study will seek to explain trends in GCC countries that are tax-exempt. This research will not focus on capital structure decisions of companies in countries other than GCC (especially Kuwait). Previous studies have indicated that capital structure decisions of companies from developed countries are based on institutional factors, firm-specific and, corporate governance, tax regimes, and market-wide factors. Since the test results from these studies cannot be used to explain what happens in completely tax-exempt countries, it is difficult to make meaningful inferences to help readers and researchers understand GCC countries.

Many companies are operating in tax-exempt economies, which continue to spur the economic growth of these economies, including Kuwait. Although a lot of research has been focused on studying the financing structure of such firms, little research has been conducted to provide theoretical and empirical explanations underlying the use of debt financing to finance their activities². There is a growing need to establish research that will explore the underlying determinants of the capital structure of companies operating in Kuwait, which is a tax-exempt country.

There are several merits of studying the capital structure and decision model for tax-exempt companies. Since debt ratios of non-taxable companies do not influence corporate taxes, tax-exempt firms are good sources of information that can be used to understand the theory of capital structure³.

One thing that makes it difficult to study and compare the capital structure of taxable organizations is the challenge of estimating the marginal tax rates, as well as the endogeneity of these companies.

In their study, Wurgler & Baker (2002) and Leary & Roberts (2005) observed that complexity noted makes it difficult to identify absolute reasons why companies may opt for debt instead of own financing⁴.

Some studies have shown that companies in a tax-exempt country behave as though they competed for debt accumulation, or have target levels of accumulating tax-exempt debts. They also indicate that tax-exempt companies design strategies for obtaining tax-exempt debts under the constraints of capital projects in which to invest. This is to means that as debt increases, organizations show an increase in the level of their tangible assets. However, similar studies demonstrate that service companies registered low profitability with increases with the amount of debt held.

The study makes significant contributions to the existing body of knowledge about capital structure. This will also allow the researcher to control the size of the firm and other industry-specific effects that have not been factored in past studies. This research will go beyond the usual leverage and simple ratio of debts to include various elements relevant to explaining the underlying phenomenon. These include tax-exempt, taxable debt, and financial debt ratios.

While abundant literature examines the significance of firm-specific factors in determining the financing decisions, the effect of tax-free economies in determining the choice of capital structure is limited⁵. According to the studies conducted by Baker and Wurgler, the effect of debt ratios, asset tangibility are relevant in explaining the capital structure decisions of firms⁶. Other studies such as those conducted show that macroeconomic factors such as asset growth, inflation, and firm-specific factors play a significant role in determining the capital and financial structure of a firm⁷.

Although variations are eminent, all the studies arrive at similar conclusions concerning the role of firm-specific factors in controlling the mode of financing. However, there is a need to formulate a holistic approach that can explain other factors that have not been researched by the preceding studies. Because companies in tax-exempt countries enjoy the benefits of accessing non-taxable debt, it is important to study industry-specific factors that may explain similarities and differences in the capital structure and financial structure of companies in Kuwait, which is the focus of the study.

Both studies arrive at similar conclusions about the relationship between debt financing and firm-specific factors. For example, studies have shown a negative relationship between debt financing and profitability. However, it is worth noting that this relationship is constrained by the quality of the management of the debt portfolio. Developments in the stock market cause replacement of debt financing with debt-equity, especially in the developing economies⁸.

Although these studies provide important insights on the effect of market-specific factors in determining capital structure decisions, these studies base their results and findings on mixed data from developed and emerging economies. For this reason, this research offers unique insights on how companies from a selected country with its heterogeneous characteristics. This will allow the researcher to use uniform data, collection procedures, and similar variables⁹.

The results of this paper will seek to address the literature gaps in several ways. The existence of limited literature on the capital structure of firms in GCC and tax-exempt countries forms the basis of this paper.

There are limited explanations that can qualify contributions of theories of capital structure of firms as applies to GCC countries. Therefore, this research will add relevant information and insight about distinct features of firms operating in tax-free markets in GCC countries.

The market within the GCC countries is unique to the extent that the capital markets are relatively young and that companies in these markets have low risks associated with debts. In addition, these markets are dominated by the private sector, and the economies are exclusively dependent on the world economy.

The study setting affords to provide the field with literature about the capital structure of corporations in a non-tax economy. The paper will extend the current literature by re-evaluating the concept of capital structure decisions of countries with and without taxation policies. The recognition of the lack of studies that relate industry-specific factors would have a far-reaching contribution to the body of knowledge in the field.

This study will be a cross-sectional analysis of firms from various industries. This shall make facilitate comparisons, generalizations and avoid biasness of associated with past studies.

The model that is adopted by this research is the dynamic model, which is relevant in studying corporations in emerging markets experiencing market dynamics. The rest of the paper is organized as follows. The section that follows discusses the methodology and framework of the study.

Research Design & Methodology

This research will utilize a theoretical framework involving three broad approaches that will explore the subject of the study. These theories include the static trade-off, pecking order theory, and agency cost theory. Previous studies have confirmed that these theories provide meaningful insights into some of the key firm-specific factors that influence an organization’s capital structure. This section will deal with a discussion of the three theories of capital structure to help in understanding the empirical design of the research.

Pecking Order Theory

The pecking order theory developed by Myers and Majluf (1984), suggests that external capital sources are affected by adverse selection because of asymmetry of information. In simple terms, they found that since internal management has more information than outsiders do, company executives tend to cash on the ignorance of the outsiders who are in demand of a premium on top of their investments¹⁰. Companies that have a monopoly of information tend to read the behavior of investors and use it to increase their capital investments. For tax-exempt organizations, the adverse selection does not only include interest expense, but also other factors such as bond covenants, including other factors that may be decided by the executives of a firm.

This theory relies on the concept of asymmetry of information¹¹. This theory postulates that firms are unable to design or achieve optimal leverage, but can set targets, which are used as pointers for future capital capacities. This theory focuses on the costs of information and other signaling effects¹². In their studies, Myers and Majluf showed that firms prefer to finance their investments through internal finances rather than outside sources¹³.

They use such sources as depreciation expenses and retained earnings. Upon exhausting these sources, these firms move to debts to finance their activities. In cases where the debt is not sufficient, a company may move to fill its financing needs through additional equity. The theorem postulates that companies rank their sources of capital in the order of the costs of financing and the number of benefits that can be derived from such sources. In essence, they use the hierarchy order, which is justified by the financing costs. The issuance of additional equity by a company is considered the most expensive source of investment capital.

This is because equity capital is a source of capital that is affected by the informational asymmetry between a company’s existing shareholders, company executives, and prospective shareholders. However, since debts tend to have fixed returns and payments, it is least sensitive to the effects of asymmetry of information. On the other hand, internally generated finances are not affected since they have no issuing costs.

Contrary to the trade-off theory, the pecking order theory argues that there can never be a definite optimal capital that a company can use to navigate its long-term investments. The key component of this theorem revolves around how a firm chooses between external sources and internal sources of capital to finance its operations. Therefore, the pecking order theory concludes that there exists a hierarchy of choice of financing options where a firm descends from internal sources then debts, and finally equity funding.

Static Trade-Off Theory

The static trade-off theory proposes that there is no existence of an optimal capital structure and that what companies do is to set their levels of debt and formulate strategies toward achieving these targets. The model observes that a capital structure of a firm is a static trade-off that relates the cost and benefits of a firm’s equity and debt. The theory anticipates that a firm seeks to increase its debt holding to offset the marginal tax advantages by the increased cost of financial distress and bankruptcy¹⁴. In essence, the theory of static trade-off of capital structure implies assumes that since the interests are subject to tax deductions, increasing the level of debt raises the tax benefits¹⁵. On the same line of thinking, increasing the amount of debt capital stimulates default and this raises chances of bankruptcy.

Modigliani and Miller (1963) found that firms seek to reach optimal capital structure using debts because of deductibility of interest expense¹⁶. Other studies have expanded this theory to include other the probability of financial distress costs as some of the firm-specific factors that may affect the capital structure of a firm. The trade-off theory suggests that firms are always on the mission to balance the cost and returns of debt¹⁷. Companies operating a tax-exempt economy must strive to strike a balance between the costs of financing through equity and debts and minimizing financial distress arising from debt-equity.

Agency cost theory

The last theory that the research will consider is the agency cost theory, which suggests that a firm seeks to achieve an optimal level of capital by balancing between returns and costs that accompany conflicting interests. According to Meckling and Jensen (1976), agency costs refer to the cumulative costs of monitoring expenses by the bond agent, the principal, and the residential loss from such a relationship¹⁸. Meckling and Jensen argue that agency costs influence the cost financing decisions citing the role of secured debts in downsizing the costs of acquisition of debts.¹⁹.

In their studies, they suggest that using short-term financing may mitigate and solve problems of agency relationships. This is because the motivation of the shareholders to reap from debt holders tends to narrow a firm’s access to short-term debts rather than long-term debts. This helps to solve agency problems.

Because of such costs arising from agency relations, a firm is motivated to focus on a targeted debt level to lower agency costs.

If there are no effects or costs of floatation, similar adjustments are deemed continuous in all firms. In practical terms, the fact that floatation costs exist implies that there shall be a fluctuation in the debt and leverage ratios on the target debt levels. Because of this, there is a need to establish a company’s debt targets and find out how this level may change as a result of external factors. However, it is difficult to unveil this given that the target levels are difficult to tell. It means that we can only use historical information to study the behavior of companies’ target levels. In this respect, the research will use the dynamic panel approach to provide a basis to investigate a firm’s target leverage ratio.

Berger, Ofek, and Yermack (1997) found that executives who have worked in a company for a long tend to tend evading debts²⁰. In their studies, Galai and Masulis (1976)²¹, Jensen and Meckling (1976), and Stulz (1990) indicated that acquisition of debt encourages a firm’s decision-making body to engage in riskier capital investments since losses are burdens to the bondholders, while gains are channeled to shareholders²².

For tax-exempt firms, the agency cost theory anticipates that a mix of personal risk aversion, experience (entrenchment), and career concerns influences decision making on the type and amount of debt²³. The effects arising out of these factors could be more in a tax-exempt economy, or sector because of the non-existence of corporate control²⁴.

Bibliography

Baker, M & J Wurgler, ‘Market timing and capital structure’, Journal of Finance, vol. 57, no. 1, 2002, pp. 1-32.

Berger PG, E Ofek &DL Yermack, ‘Managerial entrenchment and capital structure decisions’, Journal of Finance, vol. 52, no. 4, 1997, pp. 1411-1438.

Booth, L, V Aivazian, A Demirguc-Kunt & V Maksimovic, ‘Capital structures in developing countries’, Journal of Finance, vol. 56, no.1, 2001, pp.87-130. Finance, vol. 60, no. 6, 2005, pp. 2575-2619.

Galai, D &RW Masulis, ‘The option-pricing model and the risk factor of stock’, Journal of Financial Economics, vol. 3, 1976, pp. 53-81.

Jensen, MC & WH Meckling, ‘Theory of the firm: Managerial behavior, agency costs and ownership structure’, Journal of Financial Economics, vol. 3, 1976, pp. 305-360.

Leary, MT & M R Roberts, ‘Do firms rebalance their capital structures?’, Journal of Finance, vol. 60, no. 6, 2005, pp. 2575-2619.

Modigliani F & MH Miller, ‘Corporate income taxes and the cost of capital: A correction’, American Economic Review, vol. 53, no. 3, 1963, pp. 433-443.

Myers, SC & NS Majluf, ‘Corporate financing and investment decisions when firms have information that investors do not have’, Journal of Financial Economics, vol. 13, 1984, pp.187-221.

Pandey L, ‘Capital Structure and the Firm Characteristics: Evidence from an Emerging Market’, IIMA Working Paper, 2001.

Shyam-Sunder L & SC Myers, ‘Testing Static Trade-off against Pecking order Models of Capital Structure’, Journal of Financial Economics, vol. 51, 1999, pp. 219-244.

Stulz, RM, ‘Managerial discretion and optimal financing policies. Journal of Financial Economics, 26:3-27, 1990.

Footnotes

1. L Pandey, ‘Capital Structure and the Firm Characteristics: Evidence from an Emerging Market’, IIMA Working Paper, 2001.
2. L Pandey, ‘Capital Structure and the Firm Characteristics: Evidence from an Emerging Market’, IIMA Working Paper, 2001.
3. M Baker & J Wurgler, ‘Market timing and capital structure’, Journal of Finance, vol. 57, no. 1, 2002, pp. 1-32.
4. L Pandey, ‘Capital Structure and the Firm Characteristics: Evidence from an Emerging Market’, IIMA Working Paper, 2001.
5. L Pandey, ‘Capital Structure and the Firm Characteristics: Evidence from an Emerging Market’, IIMA Working Paper, 2001.
6. M Baker & J Wurgler, ‘Market timing and capital structure’, Journal of Finance, vol. 57, no. 1, 2002, pp. 1-32.
7. M Baker & J Wurgler, ‘Market timing and capital structure’, Journal of Finance, vol. 57, no. 1, 2002, pp. 1-32.
8. L Booth, V Aivazian, A Demirguc-Kunt & V Maksimovic, ‘Capital structures in developing countries’, Journal of Finance, vol. 56, no.1, 2001, pp.87-130.
9. L Pandey, ‘Capital Structure and the Firm Characteristics: Evidence from an Emerging Market’, IIMA Working Paper, 2001.
10. CM Myers & NS Majluf, ‘Corporate financing and investment decisions when firms have information that investors do not have’, Journal of Financial Economics, vol. 13, 1984, pp. 187-221.
11. MT Leary & MR Roberts, ‘Do firms rebalance their capital structures?’, Journal of Finance, vol. 60, no. 6, 2005, pp. 2575-2619.
12. CM Stewart & NS Majluf, ‘Corporate financing and investment decisions when firms have information that investors do not have’, Journal of Financial Economics, vol. 13, 1984, pp. 187-221.
13. CM Myers & NS Majluf, ‘Corporate financing and investment decisions when firms have information that investors do not have’, Journal of Financial Economics, vol. 13, 1984, pp. 187-221.
14. MT Leary & MR Roberts, ‘Do firms rebalance their capital structures?’, Journal of Finance, vol. 60, no. 6, 2005, pp. 2575-2619.
15. L Shyam-Sunder & SC Myers, ‘Testing Static Trade-off against Pecking order Models of Capital Structure’, Journal of Financial Economics, vol. 51, 1999, pp. 219-244.
16. F Modigliani & MH Miller, ‘Corporate income taxes and the cost of capital: A correction’, American Economic Review, vol. 53, no. 3, 1963, pp. 433-443.
17. MT Leary & MR Roberts, ‘Do firms rebalance their capital structures?’, Journal of Finance, vol. 60, no. 6, 2005, pp. 2575-2619.
18. MC Jensen & WH Meckling, ‘Theory of the firm: Managerial behavior, agency costs and ownership structure’, Journal of Financial Economics, vol. 3, 1976, pp. 305-360.
19. F Modigliani & MH Miller, ‘Corporate income taxes and the cost of capital: A correction’, American Economic Review, vol. 53, no. 3, 1963, pp. 433-443.
20. PG Berger, E Ofek &DL Yermack, ‘Managerial entrenchment and capital structure decisions’, Journal of Finance, vol. 52, no. 4, 1997, pp. 1411-1438.
21. D Galai &RW Masulis, ‘The option-pricing model and the risk factor of stock’, Journal of Financial Economics, vol. 3, 1976, pp. 53-81.
22. RM Stulz. Managerial discretion and optimal financing policies. Journal of Financial Economics, 26:3-27, 1990.
23. MC Jensen & WH Meckling, ‘Theory of the firm: Managerial behavior, agency costs and ownership structure’, Journal of Financial Economics, vol. 3, 1976, pp. 305-360.
24. F Modigliani & MH Miller, ‘Corporate income taxes and the cost of capital: A correction’, American Economic Review, vol. 53, no. 3, 1963, pp. 433-443.