Measuring dependent and explanatory variables

Value: Firm value is a key variable of this thesis. In a broad sense, when we speak about value, we mean some category of firm performance. Earlier it was said that value represents a sum of cash flows that pertain to creditors and shareholders. It is true, but if we go further, this capital which a firm has issued (whether by borrowing or issuing shares), was invested in some fixed assets, capital expenditures, advertising, in R&D department or some new profitable projects. It was spent on supporting today’s operations and also for assuring that of tomorrow. And we may say that what brings profit in the future, also represents firm performance today.

Performance is a multidimensional construct, and it can have therefore several meanings. There are numerous studies that reviewed the effect of leverage on corporate performance. In these studies “performance” is reflected in accounting indicators, such as return on assets and return on equity (among others are Zeitun and Tian, 2007; Ebaid, 2009; Saeedi and Mahmoodi, 2011; San and Teh, 2011). Also, gross and profit margins are applied in some of these studies. These measures reflect profitability, so financial performance of the company. However, if a firm is profitable, it does not mean that cash flows available to this firm will cover all its liabilities and at least creditors will be paid. From the finance literature (Hillier et al, 2008; Leach and Melicher, 2012; and Merchant and Van der Stede, 2007) we know that accounting measures, such as ROI, and profitability do not really reflect the value of the company, therefore they are not used in the current thesis.

Berger and Di Patti (2006) reviewed agency costs hypothesis within banking industry and provided different approach in measuring firm performance – by using profit efficiency: “how close firm’s profits are to the benchmark of a best-practice firm facing the same exogenous conditions”. Positive leverage-performance relationship was found by authors. Practically similar to previous authors, Margaritis and Psillaki (2008) selected “X-efficiency” (productive efficiency) as a measure of firm performance, that reflects industry “best practices” in order to have a standard for comparing firm efficiency. Authors found that high leverage leads to an increase in productive efficiency, which translates into firm performance. Profit and productive efficiency are used as inversed proxies for agency costs. These measures also reflect financial and operational performance, but not the value. Besides they require sophisticated calculation and collection of extra data, which makes them not reasonable due to time limitations of the current research.

41

In the current thesis performance is reviewed from corporate finance point of view – the value of the company. The ultimate goal of any corporation is increasing value. It presumes that shareholders’ benefits are maximized. Shareholders have residual claim on company’s assets after all obligations are paid – they are paid last. So if they are satisfied, then creditors are satisfied per se. As a measure of value, we intend to use Tobin’s Q, which is a mixture of market and accounting measures: the sum of market value of equity and book value of total debt divided by book value of total assets), First of all, it considers market value of the firm while other alternatives, reviewed before, do not. It is important, because it is the way how market sees corporate performance, not the accountants of the company, who make financial statements. Market value therefore is a “fair”, not biased indicator of firm performance. Next to this, according to De Jong (2002), Tobin’s Q allows measuring and comparing “managerial efficiency and abilities that generate additional value from existing assets by producing goods and services efficiently” between companies.

Leverage: Financial leverage relates to long-term solvency ratios that “address the firm’s long run ability to meet its obligations” (Hillier et al., 2008). Financial leverage is usually determined by total debt ratio, and in empirical literature it is measured by dividing book value of total debt by a book value of total assets. Basically, leverage is a proportion of debt in the capital structure. There are variations such as short-term leverage, long-term leverage (as ratios of short- or long-term debt to book value of total assets) and market leverage (as a ratio of book value of total debt divided by market value of total assets).

Consistently with Fama and French, (2002) different results could be expected from including market and book leverage in the empirical model. For instance, market leverage has a market value of total assets in denominator, while Tobin’s Q (a measure of firm value) has market value of assets in the numerator. Lang, Ofek and Stulz (1996), De Jong (2002), Dessi and Robertson (2003) as well as Aggarwal, Kyaw and Zhao (2011) state that this could create a negative bias on the leverage coefficient. Therefore, in accordance with prior research we intend to use book leverage in the current thesis.

While testing the robustness of results, we can of course use different proxies of leverage, including market measure. Besides, some authors, e.g. Zeitun and Tian (2007), Saeedi and Mahmoodi (2011) used short-term debt and long-term debt as measures of leverage. They motivated their choice by the fact that not only the proportions of leverage matters, but also debt maturity influences firm value (due to the banking credit policy). So, large firms (less risky and of low growth) prefer to issue long-term debt. In line with this, Aggarwal, Kyaw

42

and Zhao (2011) found that in countries with high developed banking, firms have long-term relationships with banks, which allows for renegotiation of debt to avoid bankruptcy or default. Zeitun and Tian (2007) assumed that short-term debt negatively influences value, as companies become exposed to the risk of refinancing. However, Myers (1977) suggested shortening the maturity of debt as a way for mitigating shareholder-bondholder conflicts (underinvestment and wealth transfer). A more detailed information on these measures and other variables is presented in Appendix 2.