This paper provides an empirical study on the relationship between leverage and investment for firms listed on the Stock Exchange of Mauritius. It also permits the determination of other factors that may affect a particular firm’s investment. By using panel data for the year 2001 to 2008, the sample was tested in 3 different circumstances; firstly the whole sample was tested, secondly low growth firms and finally high growth firms. The results obtained give different conclusions as to which factors are the most crucial when dealing with low growth and high growth firms. But the overwhelming result remains the one where all the firms were taken into consideration. However, the most important independent variable, leverage, tests positive for the whole sample and high growth firms while it tends to be insignificant for low growth firms i.e. investment is negatively related with leverage for all firms considered and high growth firms.
Firms play a determining role in the growth, economic and social success of a country. However, the government must implement policies to aid such growth in any part of the world. Mauritius is no stranger to this universal truth and the Mauritian government has contributed a lot to the development of local firms since the independence of the country.
The years 1980s’ onwards saw the rapid development of the various sectors of the Mauritian economy and this led to increased investment in modern technologies, infrastructure, product development and product promotion. These innovations remain an important feature of Mauritian companies as it allows them to retain their competitive edge over their competitors.
There exists several sources for financing such investment the objective of the management is to find the right mix to maximise the value of the company. Financial leverage is one of them and can be described as the amount of debt used to finance a firm’s assets, projects and other aspirations. During the Great Depression, financial leverage was badly viewed as a source of financing as it was thought that it increased financial distress and led to bankruptcy of businesses. However, such thoughts are no longer widespread nowadays as firms increasingly make use of leverage to finance their activities and for expansion purposes.
Indeed, there are several reasons that justify the use of debt in a company. Issuing shares for future investment purposes is regarded as costly and dilutes the future expected earnings of existing shareholders. The issue of shares also dilutes ownership of the firm and this may send a negative signal to the market. The benefit of the tax deductibility received from interest paid increases cash flow and makes debt a valuable financing tool.
The arguments against debt is that if debt reaches a level where the costs associated with financial distress outweighs the tax benefits, then adding more debt will decrease the value of the firm and increase the probability that the firm will default on interest payments and capital repayment in the future. It must also be highlighted that the existence of risky borrowing causes a company to adopt a less profitable investment strategy. Therefore, it can be said that leverage amplifies both gains and losses.
This dissertation primarily focuses on the impact of leverage on investment and also analyses the other factors that Mauritian firms need to take into consideration when making an investment. The panel data set covers 18 companies listed on the Stock Exchange of Mauritius for the period 2001 – 2008. The rest of the project is classified as follows:
Chapter 2 provides a broad empirical review of the relations between the dependent variable investment and the independent variables leverage, sales, Tobin’s Q, cash flow, profitability and liquidity.
Chapter 3 details the methodology to be used to conduct the analysis. The econometric model adopted and the dependent as well as the independent variables are defined in this chapter. In addition, information about the data sources, the sample period, the statistical package and an overview of panel data estimation is also provided.
Chapter 4 reports the estimated results and their interpretations.
Finally, in chapter 5, a brief summary is presented together with a general conclusion as well as some of the limitations of the study. In addition, some policy implications and recommendations are also provided in that chapter.
2. Literature Review
The term Investment is frequently used in jargon of economics, business management and finance. According to economic theories, investment is defined as the per-unit production of goods, which have not been consumed, but will however, be used for the purpose of future production. The decision for investment, also referred to as capital budgeting decision, is regarded as one of the key decisions of an entity.
Leverage is a method of corporate funding in which a higher proportion of funds is raised through borrowing than stock issue. It is measured as the ratio of total debt to total assets; greater the amount of debt, greater the financial leverage. Financial Leverage is the ability of a company to earn more on its assets by taking on debt that allows it to buy or invest more in order to expand.
Nowadays financial leverage is viewed as an important attribute of capital structure alongside equity and retained earnings. Financial leverage benefits common stockholders as long as the borrowed funds generate a return greater than the cost of borrowing, although the increased risk can offset the general cost of capital.
In the past years, a large body of the literature has provided robust empirical evidence that financial factors have a significant impact on the investment decisions of firms. While traditional research on investment was based on the neoclassical theory of optimal capital accumulation (where under the assumption of perfect capital markets, the cost of financing does not depend on the firm’s financial position), more recent literature has increasingly incorporated frictions such as asymmetric information and agency problems as a source behind the relevance of the degree of financial pressure faced by the firm in determining the availability and the costs of external financing
This chapter will seek to enclose literature on the impact of financial leverage on investment and other factors that may affect investment in firms.
2 .1 Modigliani & Miller (M&M) – 1958 theory with no taxation
In what has been hailed as the most influential set of financial papers ever published, Franco Modigliani and Merton Miller addressed capital structure in a rigorous, scientific fashion, and their study set off a chain of research that continues to this day.
Modigliani and Miller (1958) argued that the investment policy of a firm should be based only on those factors that will increase the profitability, cash flow or net worth of a firm.
The M&M view is that companies which operate in the same type of business and which have similar operating risks must have the same total value, irrespective of their capital structures. It is based on the belief that the value of a company depends upon the future operating income generated by its assets. The way in which this income is split between returns to debt holders and returns to equity should make no difference to the total value of the firm. Thus the total value of the firm will not change with gearing, and therefore neither will its Weighted Average Cost of Capita (Pandey, 1995).
Many empirical literatures have challenged the leverage irrelevance theorem of Modigliani and Miller. The irrelevance proposition of Modigliani and Miller will be valid only if the perfect market assumptions underlying their analysis are satisfied
Under the original M&M propositions, leverage and investment were unrelated. If a firm had profitable investment projects, it could obtain funding for these projects regardless of the nature of its current balance sheet.
2 .2 Modigliani &Miller – 1963 theory with tax
M & M (1963) found that the corporation tax system carries a distortion under which returns to debt holders (interest) are tax deductible to the firm, whereas returns to equity holders are not. They therefore concluded that geared companies have an advantage over ungeared companies, i.e. they pay less tax and will have a greater market value and a lower WACC. Following this research, the consensus that emerged was that tax is positively correlated to debt (Graham 1995, Miller 1977) and is considered a major influence in the debt policy decision.
Modigliani et al (1963) argued that we should not â waste our limited worrying capacity on second-order and largely self correcting problems like financial leveraging â. That is firms should not be worried about growth as long as they have good projects in hand, since they will always be able to find means of financing those projects.
2.3 The Trade-Off Models
Some of the assumptions inherent in the M&M model can be relaxed without changing the basic conclusions as argued by Stiglitz (1969) and Rubenstein (1973) . However, when financial distress and agency costs are considered, the M&M models are altered significantly. The addition of financial distress and agency costs to the M&M model results in a trade-off model. In such a model, the optimal capital structure can be visualized as a trade-off between the benefit of debt (the interest tax shield) and the costs of debt (financial distress and agency costs) as presented by Myers ( 1997 )
The trade-off models have intuitive appeal because they lead to the conclusion that both no-debt and all-debt are bad, while a âmoderateâ debt level is good. However, the âtrade-off models have very limited empirical supportâ, Marsh (1982) , suggesting that factors not incorporated in this model are also at work.
Jensen and Meckling (1976) invoked a moral hazard argument to explain the agency costs of debt, proposing that high levels of debt will induce firms to opt for excessively risky investment projects. The incentive for such a move is that limited liability provisions in debt contracts imply that risky projects will provide higher mean returns to the shareholders: zero in low states of nature and high in good states. However, the higher probability of default will induce investors to demand either interest rates premiums or bond covenants that restrict the firm’s future use of debt.
2.4 Pecking-Order Theory
Initiated by Donaldson (1961), the Pecking-Order theory argues that firms simply use all their internally-generated funds first, move down the pecking order to debt and then lastly issue equity in an attempt to raise funds. Firms follow this line of least resistance that establishes the capital structure.
Myers noted an inconsistency between Donaldson’s findings and the trade-off models, and this inconsistency led Myers to propose a new theory. Myers (1984) suggested asymmetric information as an explanation for the heavy reliance on retentions. This may be a situation where managers have access to more information about the firm and know that the value of the shares is greater than the current market value. If new shares are issued in this situation, there is a possibility that they would be issued at a too low price, thereby transferring wealth from existing shareholders to new shareholders.
2.5 Investment and Leverage
One of the main issues in Corporate Finance is whether financial leverage has any effects on investment policies. The corporate world is characterized by various market imperfections, due to transaction costs, institutional restrictions and asymmetric information. The interactions between management, shareholders and debt holders will generate frictions due to agency problems and that may result in under-investment or over-investment incentives. Whenever we refer to investment, it is essential to distinguish between over- investment and under-investment.
In his model, Myers (1977) argued that debt can create an âoverhang’ effect. His idea was that debt overhang reduces the incentives of the shareholder-management coalition in control of the firm to invest in positive net-present-value investment opportunities, since the benefits accrue, at least partially, to the bondholders rather than accruing fully to the shareholders. Hence, highly levered firms are less likely to exploit valuable growth opportunities as compared to firms with low levels of leverage.
U nderinvestment theory centers on a liquidity effect in that firms with large debt commitment invest less, no matter what their growth opportunities (Lang et al, 1996). In theory, even if debt creates potential underinvestment incentives, the effect could be attenuated by the firm taking corrective action and lowering its leverage, if future growth opportunities are recognized sufficiently early (Aivazian & Callen, 1980). Leverage is optimally reduced by management ex ante in view of projected valuable ex post growth opportunities, so that its impact on growth is attenuated. Thus, a negative empirical relation between leverage and growth may arise even in regressions that control for growth opportunities because managers reduce leverage in anticipation of future investment opportunities. Leverage simply signals management’s information about investment opportunities. The possibility that leverage might substitute for growth opportunities is referred to as the endogeneity problem.
Over-investment theory is another problem that has received much attention over the years.It is described as investment expenditure beyond that required to maintain assets in place and to finance positive NPV projects. In these kind of situations, conflicts may arise between managers and shareholders (Jensen,1986 & Stulz,1990). Managers seek for opportunities to expand the business even if that implies undertaking poor projects and reducing shareholder worth in the company. Managers’ abilities to carry such a policy is restrained by the availability of cash flow and further tightened by the financing of debt. Issuing debt commits the firm to pay cash as interest and principal, forcing managers to service such commitments with funds that may have otherwise been allocated to poor investment projects.
Thus, leverage is one mechanism for overcoming the overinvestment problem suggesting a negative relationship between debt and investment for firms with weak growth opportunities. Too much debt also is not considered to be good as it may lead to financial distress and agency problems.
Cantor (1990) explains that highly leveraged firms show a heightened sensitivity to fluctuations in cash flow and earnings since they face substantial debt service obligations, have limited ability to borrow additional funds and may feel extra pressure to maintain a positive cash flow cushion. Hence, the net effect would be reduced levels of investment for the firm in question.
Accordingly, Mc Connell and Servaes (1995) have examined a large sample of non financial United States firms for the years 1976, 1986 and 1988. They showed that for high growth firms the relation between corporate value and leverage is negative, whereas that for low growth firms the relation between corporate value and leverage is positively correlated. This trend tends to indicate that to maximise corporate value, it is preferable to keep down leverage to a low level and to increase investment.
Lang, Ofek and Stulz (1996) used a pooling regression to estimate the investment equation. They distinguish between the impact of leverage on growth in a firm’s core business from that in its non-core business. They argue that if leverage is a proxy for growth opportunities, its contractionary impact on investment in the core segment of the firm should be much more pronounced than in the non-core segment. They found that there exists a negative relation between leverage and future growth at the firm level. Also they argued that debt financing does not reduce growth for firms known to have good investment opportunities. Lang et al document a negative relation between firm leverage and subsequent growth. However, they find that this negative relation holds only for low q firms, i.e. those with fewer profitable growth opportunities. Thus, their findings appear to be most consistent with the view that leverage curbs overinvestment in firms with poor growth opportunities.
Myers (1997) has examined possible difficulties that firms may face in raising finance to materialize positive net present value (NPV) projects, if they are highly geared. Therefore, high leverages may result in liquidity problem and can affect a firm’s ability to finance growth. Under this situation, debt overhang can contribute to the under-investment problem of debt financing. That is for firms with growth opportunities, debt have a negative impact on the value of the firm.
Peyer and Shivdasani (2001 ) provide evidence that large increases in leverage affect investment policy. They report that, following leveraged recapitalizations, firms allocate more capital to business units that produce greater cash flow. If leverage constrains investment, firms with valuable growth opportunities should choose lower leverage in order to avoid the risk of being forced to bypass some of these opportunities, while firms without valuable growth opportunities should choose higher leverage to bond themselves not to waste cash flow on unprofitable investment opportunities.
Ahn et al. (2004 ) document that the negative relation between leverage and investment in diversified firms is significantly stronger for high Q segments than for low Q business segments, and is significantly stronger for non-core segments than for core segments. Among low growth firms, the positive relation between leverage and firm value is significantly weaker in diversified firms than in focused firms. Their results suggest that the disciplinary benefits of debt are partially offset by the additional managerial discretion in allocating debt service to different business segments within a diversified organizational structure.
Childs et al (2005) argued that financial flexibility encourages the choice of short-term debt, thereby dramatically reducing the agency costs of under-investment and over-investment. However the reduction in the agency costs may not encourage the firm to increase leverage, since the firm’s initial debt level choice depends on the type of growth options in its investment opportunity set.
Aivazian et al (2005) analysed the impact of leverage on investment on 1035 Canadian industrial companies, covering the period 1982 to 1999. Their study examined whether financing considerations (as measured by the extent of financial leverage) affect firm investment decisions inducing underinvestment or overinvestment incentives. They found that leverage is negatively related to the level of investment, and that this negative effect is significantly stronger for firms with low growth opportunities than those with high growth opportunities. These results provide support to agency theories of corporate leverage, and especially to the theory that leverage has a disciplining role for firms with weak growth opportunities
2.6 Investment and Profitability
The idea that investment depends on the profitability of a firm is amongst the oldest of macroeconomic relationships formulated. The sharp fluctuations in profitability in the average cost of capital since the 1960s revived interest in this relationship (Glyn et al, 1990) . However the evidence for the impact of profitability on investment remains sketchy.
Bhaskar and Glyn (1992) concluded that profitability must be regarded as a significant influence on investment, though by no means the overwhelming one. Their results indicated that âenhanced profitability is not always a necessary, let alone a sufficient condition for increased investmentâ.
However, years later Glyn (1997) provided an empirical study that examined the impact of profitability on capital accumulation. He tested the impact of profitability in the manufacturing sector on investment for the period 1960-1993 for 15 OECD countries. His findings suggested that the classical emphasis on the role of profitability on investment wass still highly significant and had a very tight relationship.
Korajczyk and Levy (2003) investigated the role of macroeconomic conditions and financial constraints in determining capital structure choice. While estimating the relation between firms’ debt ratio and firm-specific variables, they found out that there was a negative relation between profitability and target leverage, which was consistent with the pecking order theory. This indicated that if leverage of the firm is low, profitability will be high and the entity will be able to invest in positive NPV projects i.e. increase investment.
Bhattacharyya (2008) recently provided an empirical study where he examined the effect of profitability and other determinants of investment for Indian firms. He found that âShort-run profitability does not have consistent influence on investment decisions of firmsâ, implying that one should concentrate on the long-run profitability of a firm. This indicates that profitability is still regarded as one of the major determinants underlying investment decisions of firms. However, he suggested that liquidity is relatively more important than profitability when it comes to firms’ investment decisions.
2.7 Investment and Liquidity