choice of short-term and long-term debt in five eastern

Journal of International Business and Law

Volume 4 | Issue 1 Article 2

2005

Choice of Short-Term and Long-Term Debt in FiveEastern European CountriesAnoop Rai

Victoria Danilevskaia

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Recommended CitationRai, Anoop and Danilevskaia, Victoria (2005) "Choice of Short-Term and Long-Term Debt in Five Eastern European Countries,"Journal of International Business and Law: Vol. 4: Iss. 1, Article 2.Available at: http://scholarlycommons.law.hofstra.edu/jibl/vol4/iss1/2

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THE JOURNAL OF INTERNATIONAL BUSINESS & LAW

CHOICE OF SHORT-TERM AND LONG-TERM DEBT IN FIVEEASTERN EUROPEAN COUNTRIES

By: Dr. Anoop Rai & Victoria Danilevskaial

I. Introduction

The capital structure of a firm refers to the proportion of debt andequity maintained by a firm. In 1958, Nobel laureates Franco Modigliani andMerton Miller published a paper theorizing that in a perfectly competitivemarket with no taxes, asymmetric information or bankruptcy costs, the debt-equity level of a firm is irrelevant in the valuation of a firm. Financialeconomists thereafter have studied this issue extensively, proving the existenceof an optimal capital, but only by relaxing one of the assumptions.

The choice between debt and equity creates a problem because of thedifferent risk return characteristics associated with each type of financing. Indebt financing, the interest payments are tax-deductible offering significantsavings to the shareholders. However, too much debt increases the likelihoodof bankruptcy. requiring shareholders to demand a higher rate of return. Theuse of debt also leads to conflicts between shareholders and creditors. At highlevels of debt, shareholders may opt for riskier projects than desired bycreditors. An equilibrium capital structure is attained at the point where the riskand return of the two competing groups are satisfied.

Another area of interest in capital structure is the choice betweenshort- and long-term debt. Short-term debt is less expensive than long-termdebt but is riskier because they need to be renewed periodically. A firm mayfind itself in a crisis if they are unable to renew their debt. usually because ofsome negative news, real or otherwise. Most failures of large corporations areprecipitated by the unavailability of short term funding, as was the case forDrexel Burnham Lambert. Enron and WorldCom. Long-term debt offers morestability but is more expensive than short-term debt.

The ability to borrow short-term debt also depends on the maturityand depth of the market. In the U.S., the market for short-term instruments likecommercial paper and repos (repurchase agreements) are well developed.Consequently, large firms can access these funds quickly and efficiently. Inother countries, the lack of an efficient short-term capital market may limittheir choices of debt. When comparing the capital structure of firms in differentcountries: not only does the cultural, social and institutional factors make animpact but also the level of development of capital markets.

The focus of this paper is to examine the choice of short- and long-term debt by firms in five countries that moved from a centrally plannedeconomy to a market based system. These five countries, Russian Federation

The article is hascl on the Honor's ssy "xrittcn b \Victoria l)anilexskaia at HofstraUniv(rsit. undLr the surxnision of Profc.,cr Anoop Rai.

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Rai and Danilevskaia: Choice of Short-Term and Long-Term Debt in Five Eastern European

Published by Scholarly Commons at Hofstra Law, 2005


(RU) Poland (PO), Hungary (HU), the Czech Republic (CZ) and Slovakia (SL),have yet to develop a well functioning capital market that is fully conducive forprivate industries to operate competitively. Reforms have been slow toimplement and rules on corporate governance are not as transparent as those inother major markets. Due to the limited choice of capital instruments, firms areforced to optimize under constraints that include a lack of liquidity, legalprotection and transparency. Different factors will therefore play a role indetermining the choice of debt in each country. We first examine whether thechoice of debt is similar in the five countries. We next attempt to identify somefactors that can explain the differences.

II. Literature Review

A substantial volume of research has examined capital structure offirms globally, with significant differences observed in different parts of theworld. We however focus our literature review on the capital structure ofEuropean and Eastern European firms.

Wanzenried (2002) found that there are considerable differencesbetween the capital structure of the continental European countries and the UK.In using financial data from 167 firms over a time period from 1989 to 1998,Wanzenried found that British and continental companies finance an average of16% of their assets with external long-term capital and both have higherleverage as the firm size increases. European firms, however, raise most oftheir funds through banks. which may also hold a large stake in the company.

In a time-series study, Bevan & Danbolt (2000) analyzed thedeterminants of capital structure of 1,054 UK companies from 1991 to 1997.Companies with high levels of growth opportunities are found to utilize morelong-term and short-term debt, although over time there is a shift towardsequity finance.

Antoniou, et. al. (2002) researched the capital structure of firms inthe UK, France, and Germany during the years 1969, 1983, 1987 and 2000.The research indicates that the market interest rate plays a role in determininglevels of long-term debt. They conclude that companies preferred not toborrow long-term when the market interest rates were high. France andGermany had higher leverage than UK. which confirms the traditional beliefthat European companies take on more debt, while UK firms prefer to use moreequity.

In a more comprehensive study, Rajan and Zingales (1995) analyzedleverage of 8.000 companies from G-7 countries for the years of 1987-1991.They did not find significant differences in leverage between bank-oriented andmarket-oriented countries. Tangibility was found to be an importantdeterminant of debt. Size had a positive correlation to leverage in all countriesexcept Germany while profitability was negatively correlated in all countriesexcept Germany. All the countries utilized public financing more heavily thenprivate financing based on the percentage of GDP. The US had by far thehighest utilization of private financing. but it was still small compared to publiccapitalization. Japan and the UK., after the US, had the highest privatefinancing capitalization. while France and Italy had the lowest.

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Journal of International Business and Law, Vol. 4, Iss. 1 [2005], Art. 2

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The capital structure of a company is also affected by the legalsystem of a country due to the laws that regulate the corporate governance offirms. For example. the depth of legal protection affects investor protection,which in turn can influence the choice of debt or equity. La Porta et al. (2000)analyzed the effects of investor protection on dividends paid to shareholders in33 countries around the world. They found that firms operating in protectivelegal environments paid lower dividends. Fast growing companies in thosecountries tended to pay smaller dividends than slow growing companies. Inpoorly protected countries, shareholders opted to take any dividends they couldget, regardless of the investment quality.

Aussenegg and Jelic (2002) studied the effects of privatization inPoland, Hungary, and the Czech Republic. The study focused on 154companies listed on the National Stock Exchanges in Poland on April 16. 1991,Hungary on June 21, 1990 and the Czech Republic on April 6, 1993 and founda decline in profitability, output, employment, efficiency, and sales peremployee. These results have not been experienced in industrial countries,suggesting that the market economies have not fully matured. They also reportthat leverage has remained constant except for slight increases in dividendpayout ratios.

Csermely and Vincze (2000) conducted a detailed research on theprivatization of firms in Hungary through 1996. Their study finds that firms inHungary have capital structures that resemble those of a transitional economy.Foreign investment was found to be an important indicator of a firm'screditworthiness.

Koke and Schroder (2003) analyzed the security exchanges in Centraland Eastern Europe (CEE). They found that the markets were significantlysmaller than that of Western Europe. Further, the CEE markets had acapitalization of approximately 18% compared to the above 50% capitalizationrates in Western Europe. The Czech Republic. Hungary. and Poland had themost developed stock exchanges. with the largest stock exchange in Poland.The Warsaw exchange showed a continuous increase in listed companies whilethe Czech Republic, Hungary and Slovakian exchanges exhibited stagnant ordecreasing growth. The corporate bond markets were found to be insignificantin all these countries, the largest being in the Czech Republic, Hungary, andPoland.

There is not much literature on the use of short- and long-term debtby firms in these countries. The few existing works on the analysis of capitalstructure in Eastern European Countries have focused mostly on one or twocountries at a time. We focus on five countries at a time and test thesignificance of four variables on the choice between short- and long-term debt.The variables are size. tangibility, profitability and growth. The scope of thepaper is similar to Bevan & Danbolt (2000) who also focused on the choicebetween short- and long-term debt.

III. Hypothesis

Four hypotheses are tested in this study. Since long-term debt andshort-term debt do not show high correlation, we are able test the variables

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together. Unlike in developed countries, large companies in these five countriesare expected to prefer long-term debt because of the lack of a well-developedequity market. Smaller banks may have no option but to opt for short-term bankdebt.

Hypothesis 1: Company size is positively related to Long-termDebt and negatively related to Short-term Debt.

Company size is hypothesized to be positively related to long-termdebt. Since the equity markets in Eastern European countries are not yet fullydeveloped, companies may be forced to rely on long-term debt. Largecompanies have the ability to borrow long-term debt because they have a lowerpossibility of bankruptcy than smaller companies. Smaller companies arelikely to be considered riskier by investors for lending long-term. AsWanzenried (2002) pointed out, larger firms are also less likely to facebankruptcy than smaller firms because they usually have diversified portfolios.

Further, we expect to see changes between 1997 and 2000. If long-term equity markets are developing, then size and long-term debt may decreasein 2000 relative to 1997. If equity markets continue to be under-developed, it islikely that size and long-term debt will increase in 2000.

Hypothesis 2: Tangibility is positively related to Long-termDebt and negatively related to Short-term Debt.

The relationship between tangibility and debt levels should bepositive because tangible assets can serve as collateral for loans. In theliterature, fixed costs are often used as proxies for tangibility. The larger thetangible assets, the higher the probability that the company will repay the loans.since tangible or fixed assets such as machinery can be liquidated.

We therefore hypothesize that tangibility is positively related to long-term debt and negatively related to short-term debt.

Hypothesis 3: Growth opportunities are negativelyrelated to Long-term Debt andpositively related to Short-term Debt.

Wanzenried (2002) and Bevan and Danbolt (2000) both hypothesizethat high growth companies have lower long-term debt. Wanzenried bases herargument on the costs of long-term debt, which she believes are higher whileBevan and Danbolt base their hypothesis on the empirical findings of otherstudies. However, both studies are based on firms in developed markets.

Companies that exhibit higher growth rates are not necessarily moreprofitable, since they need to invest a significant amount of money intoachieving further growth. If the equity markets in Eastern Europe are stillunderdeveloped, then companies may seek to finance their growth throughdebt. In terms of the choice between short- and long-term debt. it is likely thatgrowth companies are perceived to be riskier. Under such circumstances.banks may be the only lenders willing to lend to risky companies through short-

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term loans. However, it is also likely that growth companies will have thecapacity to borrow directly, domestically or internationally. This would resultin a positive relationship between growth and long-term debt.

Hypothesis 4: Profitability is positively related toLong-term Debt and negatively relatedto Short-term Debt.

Profitability and leverage may have a negative or positiverelationship. If companies are profitable, they may take on debt to increase theirtax shields in line with the Modiglianni and Miller proposition. However,empirically Rajan and Zingales (1995) find debt to be negatively related toprofitability.

As for the relationship between short and long-term debt, profitablecompanies are more likely to have greater access to equity and long-term debt.However, profitable companies may also have excessive risk that may make itdifficult for them to raise debt capital. Since debt and equity markets are stillnot fully developed in the five countries, firms may have to rely more on bankdebt. Thus, the relationship between profitability and short- and long-term debtis an empirical question.

V. Data:

The data consists of firms operating in Hungary, Poland, RussianFederation. the Czech Republic, and Slovakia. Income statement and balancesheet data are available for the years 1992 to 2001 for a total of 259 companies,with 46 in Russia, 93 in Poland. 44 in Hungary, 57 in Czech Republic, and 19in Slovakia. Of them. 142 companies had data from five to nine years and 117had data for less than five years. Russia and Slovakia had the least availablehistorical data. while Poland and Hungary had the most. There was not asignificant amount of data reported for years 1992 through 1994 except forPoland and Hungary. We selected the years 1997 and 2000 for our study sincethey had the most data. All data was obtained from Worldscope.

Exhibit A shows the breakdown of companies in each country byindustry groups. There are 5 transportation firms. 181 industrial firms, 24banking firms, 41 utilities firms, and 8 insurance and financial firms. Industrialfirms dominated the sample with Poland having the largest number (67) andSlovakia the lowest (17).

Exhibits B and C show the summary statistics of the data for theyears 1997 and 2000, respectively. The data is broken down by country. Adetailed description of these variables, provided by Thomson Data, is shown inExhibit D.

The 1997 data in Exhibit B shows that Russia has the largest averageassets followed by Poland. Poland had the largest long-term debt ratio whileSlovakia had the largest short-term debt ratio. Poland also had the highest profitratio followed by Hungary while Russia had the lowest. The Czech Republichad the highest tangibility ratio.

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The 2000 data in Exhibit C demonstrates that the Russian Federationcontinues to have the largest firms in the sample by total assets. Although thetotal assets for firms in all countries increased in local currencies, they declinedin dollar terms because of the exchange rates. Hungary and the Czech Republicsaw an increase in the use of long-term debt while they declined in othercountries. Hungary and Slovakia saw some increases in the use of short-termdebt while they declined for other countries.

VI. Tests and Results:

A standard regression is used to test the four hypotheses. We usedSAS to compute the following four equations.

SIZE = a + 3, (LTDi) + 32 (STDi) + riTANGIBILITY, = a + 31 (LTD) + 032 (STD) + ciGROWTHi = a + 3, (LTDi~n) + f2 (STD) + FiPROFITABILITY = a + 031 (LTD) + P32 (STD) + eiWhere i = ith firm. LTD = long-term debt and STD = short-term debt.

The regressions were run separately for each country and separatelyfor the years 1997 and 2000. We used LTD and STD as independent variablesinstead of dependent variables to be consistent with Bevan and Danbolt (2000).The results of the tests are given in Exhibit E for 1997 and Exhibit F for 2000and are discussed below.

A. Size

Hypothesis I was tested by running a regression with long-term debt(LTD) and short-term debt (STD) as the independent variables and Size as thedependent variable. Our proxy for Size was the log of net sales. Therelationship between short-term debt (STD) and Size was positive for allcountries in 1997, but the result was significant only for Poland at the 1%significance level. In 2000 the positive relationship remained the same for allcountries except Slovakia. but was significant again only for Poland at the 5%level of significance. The results therefore do not indicate that the large firmsprefer to carry more short-term debt.

The relationship between long-term debt (LTD) and Size is also notsignificant or consistent. In 1997 CZ. PO. and SL had a negative relationshipbetween LTD and Size. while HU and RU both had a positive relationshipbetween LTD and Size. However, since none of the results are significant. wesummarize that long-term debt is unrelated to size for the 1997 sample.

In 2000 there was a positive correlation between LTD and Size for allcountries, but only the results for CZ were significant at a 5% level. Thechanges in the relationships from negative to positive are likely to be the resultof developments in the long-term debt markets.

In sum. it appears that no clear relationship between short-term andlong-term borrowing and company size can be established. Our results are

6




consistent with Bevan & Danbolt who also find no clear positive relationshipbetween debt and size.

B. Tangibility

The second hypothesis, that tangibility is positively related to long-term debt, is tested by regressing LTD and STD against Tangibility as thedependent variable. The ratio of fixed assets to total assets served as a proxyfor tangibility. There is a clear and significant negative relationship for allcountries between STD and Tangibility in 1997. The significance level is 10%for HU and 1% for all others. The negative and significant relationship remainsthe same for CZ and PO in 2000, but becomes insignificant for the othercountries.

The tests indicate that there is a positive correlation between LTDand Tangibility for HU at a 1% significance level in 1997. The results for othercountries are mostly positive, but insignificant. In 2000 there is a significantand positive correlation between LTD and Tangibility for CZ at a 5% level ofsignificance and for PO at a 1% level of significance. The remaining countrieshave a positive relationship but are statistically insignificant.

Our findings are consistent with our hypothesis that tangibility isnegatively related to short- term debt and positively related to long-term debt.These results are robust and suggest that firms with large fixed assets are morelikely to have longer-tem debt, most likely because fixed assets serve ascollateral against bankruptcy.

C. Growth

The third hypothesis tests the relationships between LTD and STD asthe independent variables, while maintaining Growth as the dependent variable.We estimate Growth only for year 2000, by estimating the difference betweenlog sales of 2000 and 1997. The growth for 1997 was not estimated becausethe data prior to 1997 is scattered and incomplete. The results indicate thatthere is a significant positive relationship between Growth and LTD for HUand PO. Hungary has a 10% level of significance, while Poland has a 5% levelof significance.

The outcomes for STD and Growth are mixed and mostlyinsignificant. CZ, HU. and SL had a negative relationship, while RU and POhad a positive relationship. The t-value was only significant for CZ and HU, ata 5% level of significance, providing no support for our hypothesis.

Thus it appears that growth firms are more likely to borrow long-termdebt than short-term debt.

D. Profitability

The final hypothesis tests the relationship between profitability anddebt by regressing the dependent variable Profitability against independentvariables Long-term Debt (LTD) and Short-term Debt (STD). Our proxy forprofitability is net sales divided by total assets.

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The relationship was mostly negative between STD and Profitabilityin 1997. but only significant at a 1% level for Poland. In 2000, the negativecorrelation changed to positive for Poland but insignificant. Only Slovakiahad significant negative results, at a 10% level of significance.

The results in 1997 for LTD and Profitability were also mostlynegative and only significant at a 5% level for the Czech Republic. In 2000,the results remained mostly negative, but were significant for Poland andSlovakia at 5% and 10% levels of significance, respectively.

The findings suggest that profitability is negatively related to bothshort- and long-term debt for both periods. A likely explanation is thatprofitable companies may be using their own internal funds to finance theircapital requirements.

The tables also report estimates of the variance inflation factor fromthe regressions. The results indicate that multicollinearity is not a factor in thetests. Similarly, the estimates of the Durbin-Watson tests are also provided.They too indicate no significant serial correlation. Thus, the regressionestimates should be considered as robust and reliable.

VII. Conclusion:

The focus of this study is to determine the factors that affect thechoice of short- and long-term debt of firms in the five Eastern Europeancountries of Russian Federation, Poland. Hungary, Slovakia and the CzechRepublic. These countries are in various stages of economic development,specifically in the development of their capital markets. As these countriesmove from a centrally planned system. firms have to finance their own capital.If debt markets are underdeveloped, the firms are often forced to rely on bankfinancing. As the capital markets develop, firms have the option of not onlyobtaining equity financing but also choosing between short- and long-termdebt.

We specify four hypotheses related to the choice between short- andlong-term debt. First, large firms are hypothesized to prefer long-term overshort-term debt. Second. firms with more tangible assets are expected to havemore long-term debts, with tangible assets serving as collateral for lenders.Third. we specify that growth may have a positive or negative relationship tolong-term debt. This is because even though growing firms may have theability to borrow long-term, they may be viewed as being too risky for long-term commitments. Fourth, similar to growth, profitable firms are alsohypothesized to have a positive or negative relationship with long-term debt.

A total of 259 firms from the five countries were obtained and testedfor two periods, 1997 and 2000. The overall results support some of thehypotheses. Size does not appear to be an important factor and is not related toeither short- term or long-term debt. Tangible assets are a significant factor inthe choice of debt. The results indicate that firms with more tangible assets aremore likely to borrow long-term than short-term debt, consistent withexpectations. Similarly, high growth firms also show a positive relationship tolong-term debt. Although high growth firm may be considered riskier and aremore likely candidates for venture capital, the lack of such capital may explain

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the positive relationship with long-term debt. Finally, profitability is shown tohave a negative relationship with both short- and long-term debt suggesting thatthese firms are probably using their internal funds to meet their financingneeds.

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REFERENCES

Antoniou, Antonios. Guney, Yilmaz and Paudyal, Krishna. 2002. Detenninantsof Corporate Capital Structure: Evidence from European Countries, WorkingPapers, Centre for Empirical Research in Finance, University of Durham.

Aussenegg, Wolfgang and Jelic. Ranko, 2002, Operating Performance ofPrivatized Companies in Transition Economies- The Case of Poland, Hungar,and the Czech Republic, Working Papers, Vienna University of Technology,The University of Birmingham.

Bevan, Alan A. and Danbolt. Jo, 2000, DYnamics in the Detenninants ofCapital Structure in the UK, Department of Accounting and Finance.University of Glasgow.

Csermely. Agnes and Vincze, Janos. 2000, Leverage and Foreign Ownership inHungay, Russian and East European Finance and Trade, vol. 36. no. 3. pp. 6-30.

Koke, Jens and Schroder, Michael, 2003, The Prospects of Capital Markets inCentral and Eastern Europe, Eastern European Economics, vol. 41, no. 4. pp.5-37.

La Porta, Rafael., Lopez-De-Silantes, Florencio., Shleifer, Andrei and Vishny.Robert. 2000, Agency Problems and Dividend Policies around the World, TheJournal of Finance, Vol. LV, No. 1, pp. 1-33.

F. Modigilani and M. Miller, "The Cost of Capital, Corporation Finance andthe Theory of Investment." American Economic Review (June 1958)

Rajan, Raghuram G. and Zingales, Luigi. 1995. What Do We Know aboutCapital Structure? Some Evidence from International Data, The Journal ofFinance, Vol, L, No. 5, pp. 1421-1460.

Wanzenried, Gabrielle, 2002, Capital Structure Dynamics in UK andContinental Europe, Working Papers, University of California Berkeley, HaasSchool of Business and Institute of Economics, University of Bern.

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Exhibit A

COMPANIES IN SAMPLE BY INDUSTRY GROUPCountries: Russian Federation. Poland, Hungary, Czech Republic, and Slovakia

Country Industry Group TotalTransportation hIdustrial Banking Utilities Insurance

FinancialRussian 2 24 1 19 0 46FederationPoland 1 67 17 4 4 93Hungary 1 32 2 7 2 44Czech 1 41 3 11 1 57RepublicSlovakia 0 17 1 0 1 19Total 5 181 24 41 8 259

Notes for Exhibits B and C* All data is stated in millions* Exhibit B:

o The exchange rates used in conversions:" $0.00491/HUF- Hungary" $0.02874/SKK - Slovakia" $0.17/RUB - Russian Federation" $0.02898/CZK - Czech Republic" $0.28490/PLN - Poland" Source: http://www.oanda.com/convert/fxhistorv

" Exhibit C:o The exchange rates used in conversions:

" $0.003562/HUF - Hungary" $0.02139/SKK - Slovakia* $0.035050/RUB - Russian Federation* $0. 02659/CZK - Czech Republic* $0. 24213 1/PLN - Poland* Source: http://www.oanda.com/convert/fxhistori

" LDEBT = Long-term debt over Total Assets" SIZE = Log of Sales" SDEBT + Total Liabilities - Long-term debt over Total Assets* PROF = Net Income over Total Assets* TANG = Fixed Assets over Total Assets* GROWTH = Log of 2000 Sales - Log of 1997 Sales

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choice of short-term and long-term debt in five eastern

Documents