Capital Structure :: Economy, The Trade-Off Theory

The trade-off theory and the pecking order theory suggest a negative relation between leverage and business risk. However, supported by literature [Bennet and Donelly (1993), Huang and Song (2003), Booth et al. (2001), and Deemosak et al. (2004)] the results presented display a strong and significant positive relation between them for all the measures of leverage. This relation can be justified by suggesting that risky firms will tend to use more debt since they cannot transfer wealth from bondholders to shareholders (Bennet and Donelly, 1993) or that firms with risky investments will use higher levels of debt (Huang and Song, 2003). Additionally, a firm can increase its levels of risky investment if the costs and risk of entering into a liquidation process is low (Deemosak et al., 2004). As the Latin American firms volatility of earnings increases, they tend to rely in debt for their future investments. Focusing to the models including macroeconomic indicators (columns market as II) it can be seen that inflation has a strong and significant positive relation with leverage. The results, though, contradict with literature [Booth et al. (2001), Barbosa and Moraes (2003) and Jorgensen and Terra (2003)]. Latin American countries have experienced high rates of inflation at the end of the 1990’s; however, since 1995, inflation has been decreasing. Despite the latter, internal and external financial crisis has led inflation to rise again at the end of 1990’s and at the beginning of 2000. The results suggest that Latin American firms increase their debt levels when inflation rises because in inflationary periods nominal liabilities, such as debt, depreciate in value, thus, become more attractive to the borrower. The ratio of stock market capitalization to GDP has a negative relation with all the dependent variables, as the capital market develop become a viable alternative; f irms will tend to use less debt. On the other hand, the ratio of deposit money bank to GDP displays a positive relation with leverage - as the banking sector increases, firms will have more incentive to use more debt. For both variables, the results concur with Booth et al. (2001) and with Agarwal and Mohatadi (2004). Booth et al. (2001) argue that higher economic growth tends to increase debt ratios, however, the results illustrate that in Latin American countries economic growth is negatively related with leverage (except for the long-term debt ratio indicating that firms will choose low debt levels during expansion in the business cycle).