Dependent variable

The study uses the book debt ratio (scaled by total assets) as the main measure of capital

structure.18 Rajan and Zingales (1995) argue that the selection of the measure of leverage

depends on the objective of the analysis. As credit ratings are incorporated into the previous models of capital structure, book debt ratios become more important when the relevance of credit rating is assessed relative to factors suggested by theories of capital

structure including the trade-off and pecking order theories. For example, Banerjee et al.

(2004) argue that at the time of debt issuance, changes in the market value of debt do not affect the cash saving from the interest tax shield of the firms. Also, in the case of bankruptcy, the book values of the firms’ debt are taken as a measure of the firms’ outstanding liabilities. Therefore, the implications of credit ratings can be evaluated more directly using book debt ratios rather than market debt ratios. Kisgen (2006) also points out that the rating agencies use book values of financial ratios to evaluate firms’ creditworthiness.

Book values of debt are argued to be more realistic measures of capital structure as they are composed of the assets’ value in place and are not the capitalised future value of assets (Myers, 1977). Taggart (1977) argues that firms’ market value of debt can be the result of their actions, but the firms’ book value is what firms control and use in their financial decision-making processes (also, Baskin, 1989; Marsh, 1982). When the choice of measure is concerned i.e., book debt ratio (the book value of debt scaled by book value of assets) versus market debt ratio (the book value of debt scaled by market value of assets), survey

18 _{Accounting standards have changed over the 22 years sample period and this may affect the way in which}

debt and total assets are is measured. However, testing the relationship on an annual basis as well as regression analysis with time effects carried out in the study shows that the results are stable over time.

96 studies point towards the use of book debt ratio by firms’ managers. A survey study of financial executives of French, Japanese, Dutch, Norwegian, and American firms by

Stonehill et al. (1975), confirms the use of book debt ratios in managerial decision-making.

In a more recent survey study, Graham and Harvey (2001) find that the market value of equity may not reflect the adjustments in the capital structure made by firms. They note that firms do not rebalance their capital structure in response to equity price movements suggesting that market leverage numbers may not be very important in debt decisions (also

see, Bessler et al., 2011).

Despite the above, theories of capital structure are mostly based on the market values of

debt (Sweeney et al., 1997; Bowman, 1980); the use of book debt ratio is prevalent in the

empirical studies testing those theories (e.g., Titman and Wessels, 1988; Friend and Lang, 1998; Rajan and Zingales, 1995; Ozkan, 2001; Baker and Wurgler, 2002, amongst others). Nevertheless, Bowman (1980) also documents a high correlation between cross-sectional values of book and market debt ratios, which might suggest substituting book debt ratio for market debt ratios. It is likely that this will not have a significant impact on the inferences of the present study. More importantly, the unavailability of data also does not permit the use of market values of debt as a dependent variable. The present study therefore uses book debt ratio as the measurement of capital structure.

Four main empirical proxies are used by previous studies to measure capital structure: total book debt to total book assets (Rajan and Zingales, 1995; Ozkan, 2001; Bevan and

Danbolt, 2002; Baker and Wurgler, 2002; Deesomsak et al., 2004), total book debt to total

market value of assets (Rajan and Zingales, 1995; Friend and Lang, 1998; Bevan and Danbolt, 2002) and total book long-term debt to either book value or market value of total

assets (Titman and Wessels, 1988; Jong et al., 2008). Jong et al. (2008) note that

differences in the definitions do not have any material impact on the results and they maintain their consistency irrespective of the definition used. Bevan and Danbolt (2002) also find that the market and book measures of the simple debt ratio result in similar signs of coefficients, yet the fit of the model improves when market debt ratios are used instead. To be consistent with prior studies, the dependent variable is measured by book debt ratio where debt ratio is equal to the total debt (sum of short-term debt and long-term debt) scaled by the total assets of a firm, symbolically expressed as:

97 Where:

TDTAit is the debt ratio of the firm i at time t

it

TD is the total book debt of the firm i at time t

it

TA is the total book value of the assets of the firm i at time t

The data for the book value of debt are extracted using Datastream code: WC03255, which

defines total debt as ‘all interest bearing and capitalised lease obligations. It is the sum of

long and short term debt’.19

The book value of assets for industrial firms (Datastream

code: WC02999) as defined by Datastream is ‘the sum of total current assets, long term

receivables, investment in unconsolidated subsidiaries, other investments, net property plant and equipment and other assets’.

For a robustness check, the market debt ratio is also used, which is defined as:

Where: it

MDR is the market debt ratio

it

BVE is the book value of equity (Datastream code: WC03501)

it

MVE is the market value of equity (market price-year end*common shares outstanding, Datastream code: WC08002).

Although firms’ debts may be argued to be largely composed of long-term debt, and studies generally tend to use long-term debt ratios as a proxy for capital structure (e.g.,

Titman and Wessels, 1988; Jong et al., 2008), a growing literature suggest that a debt

maturity structure has different set determinants and that it should be recognised as separate from the capital structure. Therefore, the present study focuses on analysing the long-term debt ratios of firms separately from a capital structure analysis. Further discussion on the differences between debt ratio and debt maturity ratio is postponed until Subsection 5.2.3.1.