Country-level control variables

Inflation

Inflation variable is expressed as the annual percentage change in consumer price index, as reported by the World Development Indicators of the World Bank (n.d.b), the World Economic Outlook Database of the International Monetary Fund (2014) and the Consumer Prices Database of the OECD (2015). As debt contracts are written in nominal terms, changes in inflation always tend to have real effects (Gomes, Jermann & Schmid, 2014, p. 3).

However, the direction of the effect that inflation has on firm’s leverage is ambiguous.

On the one hand, inflation can lead to higher risk premiums and higher nominal interest rates, which decrease the attractiveness of debt. Inflation can also reduce the tax advantage of debt by decreasing the real value of deductible interest payments if the payments depend on the historical value of debt and if interest rates are fixed (Huizinga et al., 2008, p.

100).

On the other hand, the trade-off theory states that leverage is positively related to expected inflation (Frank & Goyal, 2009, p. 19; Taggart, 1985, p. 40). Several studies that examine the effect of inflation on firm’s capital structure conclude that inflation enhances debt financing as it decreases the real value of currently outstanding corporate debt, improves firm’s balance sheet and decreases its default risk (Hochman & Palmon, 1985; Modigliani, 1982). Furthermore, nominal interest payments consist of the actual interest payments and a compensation for reduction in the real value of the principal. Firms are allowed to deduct their entire nominal interest expense for the corporate income tax, which implies that an increase in the nominal interest rate induced by inflation increases the tax advantage of debt (Gu, de Mooij & Poghosyan, 2015, pp. 184, 198; Jaffe, 1978, pp. 1442 – 1443). Hence, the share of pre-tax operating income paid in taxes declines with the rate of inflation and debt financing becomes more attractive (Mintz & Weichenrieder, 2010, p. 132; Modigliani &

Cohn, 1979, p. 27).

Corruption

Corruption variable is expressed as a logarithm of annual corruption index in each country, as reported by the Worldwide Governance Indicators of the World Bank (n.d.a). The variable shows the extent to which public power is used to obtain private benefits and captures the risk of investors’ expropriation by firm’s management or by public officials and politicians. The index shows the country's score in a range from -2.5 to 2.5, with 2.5 indicating a country with a very low level of corruption.²² Thus, the higher the index, the less corrupt the country. As revealed by the previous research, the effect of corruption on firm’s leverage is ambiguous.

Several authors find that corrupt countries have more indebted firms, which can be explained by two reasons. Firstly, as debt obligations are contractual and legally binding, debt provides a higher degree of monitoring ability and enforcement by investors than equity.

More indebted firms tend to be more protected from expropriation by managers or bureaucrats, which increases the attractiveness of leverage in corrupt countries (Fan, Rui &

Zhao, 2008, p. 346; Venanzi, Naccarato & Abate, 2014, p. 24). Also, as found by Han, Titman and Twite (2012), firms that operate in countries characterized by weak laws and high public sector corruption tend to have high leverage and borrow more short-term debt, as short-term debt is harder to expropriate (p. 29). Secondly, it may be easier for a corrupt bureaucrat to channel funds to connected firms as loans through a bank that he controls, rather than through equity market that he cannot influence to such an extent (La Porta, De Silanes & Shleifer, 2002; Sapienza, 2004).

However, the effect of corruption on firm’s leverage can be negative, as it may be harder to obtain credit in countries characterized by high corruption. Also, interest rates are likely to be higher in countries with weak legal efficiency, where creditors are exposed to a high risk and low negotiation power in the event of borrower’s default (Aggarwal & Kyaw, 2008, p. 416). Moreover, firms may consider it risky to borrow in countries characterized by a highly corrupt public sector.

Growth opportunities

Growth opportunities variable is expressed as the median annual growth in sales per industry and country, following Huizinga et al. (2008, p. 100) and Møen et al. (2011, p. 18).

22 I have adjusted the range of corruption index to be within [0;10] interval, where 10 indicates a country with a very low level of corruption. The logarithm is taken from these adjusted values.

As revealed by the previous research, the impact of growth opportunities on firm’s leverage is ambiguous.

As revealed by the existing literature on agency problems, firm’s stockholders tend to make sub-optimal investments in order to extract wealth from debtholders and maximize equity value rather than the total firm value. Increased growth opportunities enhance this conflict as there is more flexibility regarding firm’s future investments. Firstly, managers may have incentives to underinvest in future growth opportunities, which is described as the underinvestment problem (Johnson, 2003, p. 209; Rajan & Zingales, 1995, p. 1456). The reason is that a portion of benefit from investments in growth opportunities belongs to debtholders, which implies that the net present value accruing to stockholders can be even negative. Furthermore, managers may be willing to overinvest in future growth opportunities if these investments are substantially more risky than the firm’s current assets. Moreover, managers may undertake risky negative net present value projects, which increase the value of equity and decrease the value of risky debt even more (Jensen & Meckling, 1976).

Reduction in firm’s value due to less efficient investment decisions is an important component of agency costs of debt. If bondholders are rational, they anticipate these stockholder incentives and require a higher cost of debt (Billett, King & Mauer, 2007, p.

700). Therefore, it is in the firm’s and stockholders’ interests to reduce the potential conflicts regarding future growth opportunities. This can be done through reducing firm’s debt, including restrictive debt covenants in agreements, or decreasing debt maturity (Barclay, Marx & Smith, 2003, pp. 150, 154, 161; Barclay & Smith, 1995, p. 610; Myers, 1977, p.

161).

Furthermore, Titman and Wessels (1998) claim that growth opportunities can be considered as assets that increase firm’s value, but do not act as a collateral nor create any current taxable income (p. 4). Hence, borrowing can be difficult for firms which have low current income or low tangible assets, even though their growth opportunities are high.

Therefore, debt and growth opportunities are likely to be negatively related.

However, several studies find a positive relation between growth opportunities and leverage. If owners of a rapidly growing firm consider growth opportunities unsustainable and risky, they are willing to pass on the higher risk to debtholders. Also, if a substantial new growth opportunity is discovered, the owners of the firm might be unwilling to issue equity, as the price might not be high enough to reflect the firm’s actual value. The owners may prefer to finance the new investment initially with debt, and when the project becomes

profitable, the firm may pay back its debt by issuing equity at a much higher price or through retained earnings. Moreover, the economic and political networks of owners of rapidly growing firms may provide them with an easy access to the credit market. It has also been observed that the credit market is more likely to finance firms with better future growth expectations (Awan, Bhatti, Ali & Qureshi, 2010, p. 96). Another explanation for the positive relation between growth opportunities and leverage is that firms with rapidly growing sales often need to expand their fixed assets (Gupta, 1969, pp. 524, 528). These firms have a greater future need for funds and also retain more earnings. Therefore, according to the trade-off theory, high-growth firms are willing to issue more debt in order to maintain their target debt-to-asset ratios, which shows a positive relationship between leverage and growth opportunities (Awan et al., 2010, p. 91).

Creditor rights

Creditor rights variable is expressed as a logarithm of annual strength of legal rights index as reported by the World Development Indicators of the World Bank (n.d.c). The index describes how well collateral and bankruptcy regulations protect the rights of borrowers and lenders, thereby promoting borrowing and lending within a country. The index ranges from 0 to 12, with higher values indicating that the regulations protect the rights of borrowers and lenders and increase access to credit.²³ As revealed by the previous literature, the impact of creditor rights on firm’s leverage is ambiguous.

On the one hand, the supply side view, which focuses on the supply side of the financial market or investors, suggests that strong creditor protection induces lenders to provide credit at more favourable terms, promotes finance and growth and leads to a higher corporate leverage (Demirgüç-Kunt & Maksimovic, 1998, p. 2122; La Porta, Lopez-De-Silanes, Shleifer & Vishny, 1997, p. 1149; Qian & Strahan, 2007, p. 2821). Moreover, strong creditor rights lead to a better allocation of resources (Vig, 2013, p. 924). As claimed by González and González (2008), when creditor rights are weak, firms with high agency costs of debt find it hard to borrow because financial institutions expect underinvestment and other issues (p. 365). Thus, lenders in countries characterized by weak creditor protection tend to require high levels of collateral and demand collateral forms that have a small dilution risk (Davydenko & Franks, 2008, p. 601). Also, lenders require increased control rights via specific agreements; for example, restrictive covenants that demand low dividend payments

23 I have adjusted the range of creditor rights index to be within [0;10] interval, where 10 indicates a country with a very high creditor protection. The logarithm is taken from these adjusted values.

of debtor firms (Brockman & Unlu, 2009, p. 276; Miller & Reisel, 2012, p. 7; Nini, Smith &

Sufi, 2009, p. 401). Lenders may also be willing to lend short-term in order to control borrowers’ opportunistic behaviour by threatening of not renewing the loan. Higher creditor protection reduces these issues and increases firms’ access to credit. Credit access is especially improved for firms with substantial proportion of intangible assets (assets that cannot be used as collateral, such as R&D and advertising), with low profitability, high growth opportunities and highly volatile returns. Giannetti (2003) finds that in the U.K., which has very strong creditor rights, firms with highly volatile returns are still able to borrow long-term. Strengthened creditor rights make the use of debt maturity to control borrowers inessential. Therefore, lenders are willing to increase debt maturity for firms with volatile returns, which increases survival of temporarily illiquid firms (p. 200).

On the other hand, the demand side view, which focuses on the demand side of the financial market or corporations, suggests that strong creditor protection makes firms unwilling to make long-term cash flow commitments to repay debt. In countries characterized by strong creditor rights, management can be easily laid off upon default and replaced by creditors or neutral third-party trustees. As managers do not want to lose job and control upon financial distress, they tend to issue less leverage in countries characterized by strong creditor rights (Cho, Ghoul, Guedhami & Suh, 2014, p. 41; Rajan & Zingales, 1995, p. 1444).