Capital Structure in the Chilean Corporate Sector: Revisiting the Stylized Facts

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Capital Structure in the Chilean Corporate Sector: Revisiting the Stylized Facts Structured abstract:

Purpose: This paper analyzes the traditional drivers of the capital structure in addition to others particularities of the Chilean corporate sector.

Design/methodology/approach: Using panel data methodology, this study examines the potential drivers of the capital structure in a sample of 157 Chilean firms. To do that, this study also includes variables not commonly used in the literature (e.g. ownership concentration, business groups affiliation, and dividends), which represent distinctive elements of the Chilean corporate sector. Findings: The results show a positive effect of firm size and ownership concentration on the leverage of firms, as well as a negative effect from the pay-out policy, growth opportunities, non-debt tax shields, and profitability on the leverage. Some expected relationships from the Anglo-Saxon context are also curiously observed in Chile. Nevertheless, there are some relations that are not in line with the current literature such as the negative relationship between asset tangibility and leverage. Finally, a firm´s affiliation to certain economic groups allows it to take advantage of internal capital markets, thus increasing leverage. This suggests that some of the insights from the current theoretical frameworks are not portable across countries, and consequently, much remains to be done to understand the impact of different institutional features on capital structure choices. Originality/value: Emerging markets provide a challenge to existing models that need to be reformulated to accommodate their specific characteristics. This study contributes to this by taking into consideration the particularities of an emerging Latin American Economy.

Paper type: Research paper.

Key words: Capital structure, debt, panel data, Chilean firms, business groups.

JEL Classification: G32.

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1. Introduction

Capital structure choice has been a controversial and recurring issue in corporate finance. Myers

(1984) in his work “The capital structure puzzle” raises the question: “how do firms choose their

capital structures?” and answers succinctly: “we don’t know”. Therefore, the seminal findings of

Modigliani and Miller (1958), (1963) continue inspiring us to this day to research the determinants

of capital structure policy. Currently, there is still no consensus on the capital structure puzzle and

on its determinant factors from a scholar point of view (Myers, 1984, Myers and Majluf, 1984,

Al-Najjar and Hussainey, 2011).1

The most salient contributions on capital structure decisions are based on empirical analyses of

public firms traded in economies with developed financial systems and low levels of market

frictions (Titman and Wessels, 1988, Rajan and Zingales, 1995, Frank and Goyal, 2009). However,

only a few works have been developed with samples of firms from developed and developing

countries (Demirgüç-Kunt and Maksimovic, 1999, Fan et al., 2012, Öztekin, 2015), and fewer yet

on firms from developing regions only (Booth et al., 2001, Gómez et al., 2014). Emerging markets

provide a challenge to existing models and suggest the need for brand new approaches of analysis

(Bekaert and Harvey, 2002). These last works demonstrate that capital structure decisions made in

firms of developing countries are highly influenced by institutional structures which are radically

different from those of more advanced countries. This drives us to focus our analysis on the

different dynamics across countries which impact the way companies set their capital structure

choices.

The goal of this work is to study the capital structure decisions for an emerging economy, the

Chilean corporate sector, based on the most important theories –trade off, pecking order, market

timing, agency costs, and signaling theories– which at the same time are contextualized according

to the particular dynamics of the Chilean corporate sector.

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The major contributions of the paper are, first, that we focus on a sample of firms from an emerging

market that so far have been overlooked in the empirical literature, thus expanding the determinants

usually treated in the literature to explain capital structure decisions. This allows us to compound a

more comprehensive approach than that usually applied in the empirical literature by considering

for instance, the characteristics of the corporate ownership structure in Chile (e.g. high

concentration of ownership and prevailing business groups). Second, we proceed by employing an

empirical technique that properly accounts for cross-sectional and time series variation, as well as

for endogeneity and the heterogeneity problems. Additionally, since growth opportunities are

always a controversial variable, we use two proxies to capture the intrinsic idea of Tobin’s Q. Third,

through our research we conclude that modern finance models are not necessary transferable from

developed to developing countries unless local corporate characteristics are considered. In fact,

certain particularities of developing countries might derive opposite relationships from those

suggested by current theoretical models.

Our results confirm a positive effect of firm size and ownership concentration on firms leverage, as

well as a negative effect of the pay-out policy, non-debt tax shields, growth opportunities, and

profitability on the leverage. Nevertheless, there are some relations that are not in line with the

current theories such as the negative relationship between asset tangibility and leverage. Finally, a

firm´s affiliation to certain business groups allows it to take advantage of the internal capital

markets and increase its use of leverage.

The paper continues in the second section with the literature review and the development of the

research hypotheses. The third section describes the data set, variables, and the methodology used

in the empirical analysis. Section 4 summarizes the main results with section 5 concluding.

2. Theoretical framework

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Chile is an emerging Latin American economy, categorized as a French Civil-Law country (La

Porta et al., 2008), but its financial system is more representative of one oriented toward capital

markets rather than banking (Djankov et al., 2008). An example of this is the high market

capitalization which was about 125% of the GDP between 2009 and 2012. Its financial deepness

increased from 46% of GDP in 1981 to 276% in 2011, and it is financially the most sophisticated

country in South America (La Porta et al., 1998, Beck et al., 2008). The rapid growth of the capital

market in Chile is the result of a cumulus of capital market reforms that originated in the1980s and

consolidated along the 1990s, relaxing, for instance, a number of restrictions to the capital account

and easing the issuance of corporate bonds and stocks in foreign markets (Gallego and Loayza,

2000). The development of the capital market regulation has replicated to a large extent the models

followed in developed markets and particularly in the USA (Lefort, 2003).

As a consequence of the privatization process during the 1970s and 1980s and since only a few

private agents were allowed to take part in it, this led to the subsequent concentration of ownership

and the formation of specific business groups (Silva et al., 2006, Buchuk et al., 2014). This fact

encouraged the development of pyramidal ownership structures linked to well-diversified business

groups (Lefort and Walker, 2007, Majluf et al., 1998, Lefort, 2003, Khanna and Yafeh, 2007);2

which originated internal capital markets within the conglomerates (Buchuk et al., 2014). This fact

implies that the horizontal majority-minority shareholders agency problem is perhaps more serious

than the traditional principal-agent agency problem (Araya et al., 2015, Saona, 2014, Lefort and

Walker, 2007). The spirit of the regulation was to try to make more transparent the information

flows between minority and majority shareholders as well as to strengthen the rights of the former.

For instance, the legislation defines the relevance of independent directors and the payout of a

mandatory dividend of at least 30% of earnings (La Porta et al., 2000).

2.2. Literature review

2 Cross-holdings among firms are forbidden by law. This makes the pyramidal structures relatively simple and straightforward to understand.

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Since Modigliani and Miller (1958) proposed that capital structure was irrelevant, several theories

have been developed in order to reconcile the capital structure puzzle. Trade-off and pecking order

theories are the two most prominent. The former holds that managers try to balance tax benefits

with bankruptcy costs of debt (Myers, 1984), whilst pecking order theory suggests that the

asymmetries of information between the firm and its creditors lead to an undervaluation of the

securities issued by firms. This increases the financing cost of external sources in comparison with

internally generated funds and leads firms to follow a funding hierarchy, with a preference for debt

over equity (Myers, 1984, Myers and Majluf, 1984).

Additional scientific advances in corporate finance have led to new theories about the capital

structure puzzle. Agency considerations (Jensen, 1986, Jensen and Meckling, 1976, Myers, 1977),

market timing (Baker and Wurgler, 2002) and signaling theory (Ross, 1977, Leland and Pyle, 1977)

all point to new potential drivers of capital structure choice. Such drivers considered in this study

are analyzed in the following sections.

2.2.1. Firm size:Most studies reveal that a firm’s size and debt level are correlated. Rajan

and Zingales (1995) suggest that firm size seems to be inversely related to the bankruptcy risk and

that larger firms have fewer problems with information asymmetries as they are required by law to

disclose more relevant information than smaller firms. Large firms are also more diversified and

have less volatile cash flow streams which increase their debt capacity (Ghosh, 2007). Banks are

more willing to lend their funds to large diversified firms, which in turn also usually request a larger

amount of debt capital than smaller firms (Eriotis et al., 2007). Large firms are also more financially

sophisticated and may reduce transaction costs so that they can negotiate debt contracts at a lower

cost (Frank and Goyal, 2009, Booth et al., 2001, De Jong et al., 2008). Regarding these arguments,

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2.2.2. Profitability: There is no consensus in the literature on the relationship between profitability and debt level. On the one hand, the pecking order theory suggests that profitable firms

are likely to have more retained earnings. Thus, a negative relation between debt and past earnings

should be expected (Titman and Wessels, 1988, Harris and Raviv, 1991, Rajan and Zingales, 1995).

On the other hand, trade-off theory posits that the relationship between profitability and leverage is

positive. More profitable firms are likely to get more external funds to take advantage of tax shields

(Fama and French, 2002).

For emerging market economies, Booth et al. (2001) and De Jong et al. (2008) find a negative

relationship between profitability and debt. Similar findings are recorded by Maquieira et al. (2007)

and Céspedes et al. (2010) for Latin American countries. The underlying reason is that the cost of

debt is relatively higher in developing than in developed economies (Bekaert and Harvey, 2003, La

Porta et al., 1998). Consequently, firms will primarily use retained earnings according to the

pecking order approach. Thus, we may expect a negative relationship between profitability and

leverage.

2.2.3. Tangibility of assets:According to agency theory, shareholders of levered firms have

an incentive to invest suboptimally. However, tangible assets are more likely to become

collateralized in debt agreements, reducing the adverse selection problems as a signal about the

firm’s credit quality (Benmelech and Bergman, 2009). Collateralized assets can restrict such

suboptimal behavior supporting a positive relationship between asset tangibility and leverage.

Booth et al. (2001) suggest that the factors that influence capital structure choice are similar

between developed and developing countries. However, they also suggest that the signs on some of

the coefficients are sometimes the opposite of what one would expect. In fact, Ferri and Jones

(1979) suggest that the use of fixed assets can increase the risk of the firm’s future income and

consequently the operating leverage should be negatively related to debt. We believe that this is

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might be negative in certain circumstances, for instance, when tangible assets reduce information

asymmetries which eventually allow equity to be less expensive than debt (Booth et al., 2001).

Equity markets in Chile have experienced a substantial development over the last three decades. As

a result, the cost of common equity became more sensitive to changes in firm risk. Therefore,

although tangible assets can be used as collateral to issue more debt, it is even easier for firms to

issue equity for financing their capital expenditure on tangible assets. Hence, a negative relationship

between tangibility and leverage is expected.

2.2.4. Growth opportunities: In Myers (1977) words, financing a firm’s operations with

risky debt might push managers not to accept positive NPV investment projects, suggesting that

debt level is negatively related to growth opportunities.

On the one hand, from a signaling perspective, growth opportunities are intangible in nature and

cannot be collateralized (Cantillo and Wright, 2000). On the other hand, growth may serve as an

alternative quality signal which hypothesizes less need for leverage for high quality firms

(Korajczyk and Levy, 2003, Titman and Wessels, 1988). Consequently, growing firms should

employ lower leverage.

The relationship between growth opportunities and leverage has been widely tested within the

Anglo-Saxon context, typically for US firms. Nevertheless, the Latin-American case in general (and

the Chilean in particular) has been barely studied (De Jong et al., 2008, Céspedes et al., 2010).

Since the Chilean capital market is relatively developed, we expect that the relationship between

growth options and the leverage to be more in line with the option model (Myers, 1977) and the

pecking order model (Myers and Majluf, 1984). Consequently a negative relationship between

growth opportunities and a firm’s leverage is expected.

2.2.5. Non-debt tax shields: DeAngelo and Masulis (1980) extend Miller (1977) analysis

to show that the existence of non-debt tax shields such as depreciation deductions or investment tax

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model predicts that firms will select a debt level that is negatively related to the level of tax shield

substitutes for debt. As firms increase non-debt tax shields, they appear less interested in debt than

the income-substitution effect (López and Sogorb, 2008). Additionally, the trade-off theory predicts

that firms with high levels of tax shields different than debt will issue less debt because both of

them are substitute ways to obtain financing funds (Myers, 1984).

According to the accounting depreciation rules passed (Legal Resolution No 43), the depreciation

schedule in Chile is even faster than in the USA, Canada, Germany and others developed countries.

This new regulation created significant reductions in the number of depreciable years of fixed

assets, suggesting that the depreciation tax-shield is more appealing as a substitute for debt. Thus,

we should expect a negative empirical association between the non-debt tax shields and leverage.

2.2.6. Market timing: Market timing theory posits that corporate executives issue securities

depending on the time-varying relative costs of equity and debt (Baker and Wurgler, 2002). This

means that firms adjust their leverage to time the market valuation by taking advantage of windows

of opportunity (Graham and Harvey, 2001). Under efficient and integrated capital markets, a la

Modigliani and Miller (1958), the costs of different forms of capital do not vary independently so

there is no gain from opportunistically switching between equity and debt. In capital markets that

are less efficient or segmented, by contrast, market timing benefits existing shareholders at the

expense of newly entering ones. Managers thus have an incentive to time the market if they think it

is possible and if they care more about ongoing shareholders (Baker and Wurgler, 2002). In their

survey, Graham and Harvey (2001) reveal that two thirds of CFOs agree that the market price per

share is important or very important when considering new issuances of common equity.

Firms in Chile can reduce their leverage by issuing additional stocks whenever the stock price is

overvalued. Nevertheless, this timing effect might be constrained due institutional issues. For

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Law of Public Corporations No18.046 (Article 27) stresses a number of conditions under which the

corporations can repurchase their own shares. All these conditions make the repurchase under the

market timing approach almost unfeasible. As a result, we suggest a negative relationship between

firm leverage and the market timing condition.

2.2.7. Ownership structure: Corporate ownership plays a crucial role as a governance

mechanism (Yafeh and Yosha, 2003). Thus, the higher the number of shares in the hands of the

same shareholder, the greater will be his or her incentive to control managers and reduce agency

conflicts (La Porta et al., 1999).

As a matter of fact, one of the most important characteristics of corporate ownership in Chile is the

widespread use of pyramidal structures (Lefort and Walker, 2007). Moreover, there is evidence that

business groups are an efficient mechanism to deal with the lack of more developed markets by

developing internal capital markets (Maquieira et al., 2012, Buchuk et al., 2014). In this line,

Buchuk et al. (2014) suggest that the controlling shareholders within the group may act

benevolently with other intra-group firms to provide funding. They also argue that those firms that

get intra-group lending might improve their return on equity since the cost of funds cannot be

greater than prevailing interest rates.

We believe that the pecking order theory might become more relevant in the context of big Latin

American corporations for two reasons. First, controlling shareholders try to avoid ownership

dilution by issuing debt before equity, and second, equity issuances are still relatively more

expensive in emerging markets than in developed economies. Consequently, concerning the

ownership concentration, we hypothesize a positive relationship with leverage, and concerning the

group affiliation it is expected that leverage be higher for firms belonging to a business group.

2.2.8. Dividends: the literature points out that firms pay dividends to signal inside

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sense, the dividend pay-out might be used as a reliable signal for the financial position of a firm,

implying a higher debt capacity. Firms that pay out dividends and simultaneously increase their

leverage signal their credit quality to the capital markets (Ferris et al., 2009). Hence, a firm that

periodically pays out cash dividends is obliged to obtain external financing for its profitable

investment projects. In these cases, the firm is scrutinized by outsiders in the capital markets from

where the company obtains the external funds, and therefore, managerial behavior is supervised by

the participants in such markets (Easterbrook, 1984, Short et al., 2002). Thus, from this point of

view, one would expect a positive relationship between dividend payments and debt level.

Nevertheless, agency problems also seem to be one of the most important drivers of dividend policy

worldwide. For instance, La Porta et al. (2000) analyze the extent to which minority shareholder

rights influence dividend policy for several countries and its impact on the agency cost of equity.

They find that strong shareholder rights enable minority shareholders to obtain relatively high

dividend pay-outs from reluctant managers and controlling shareholders. In fact, La Porta et al.

(2000) argue that mandatory dividends are used only in the French-civil law countries like in Chile

(where they represent 30% of earnings). Consequently, these arguments support a negative

relationship between the dividend pay-out policy and the debt level.

3. Sample, Variables, and Methodology 3.1. Sample description

The empirical analysis was done with an unbalanced panel data of 157 non-financial firms quoted

in the Chilean Stock Exchange for the period from 2002 to 2010, comprising a total of 1,050

firm-year observations. The dataset was obtained from the Economatica Data Base. As in similar studies,

we exclude all financial firms from the analysis. We also exclude firms with negative equity and

firms with missing values for relevant variables.

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The variables considered in the empirical analysis are directly related to the theoretical framework

described above (see details in the Appendix). Two alternative measures for dependent variables are

used in order to test for the consistency of our findings. The first measure is the leverage (Lev) at

book value (Frank and Goyal, 2009, Welch, 2011) and the second is the leverage at market value

(Lmv).

The first independent variable is the firm’s size (Size) based on the firm’s total assets. For

profitability (Prof) we use return on assets, whilst for tangibility (Tang) we use a measure which

considers the fixed assets. The growth opportunities variable is measured with Tobin’s Q. We use

two alternative proxies for this: Q1, based on the reposition cost of total assets (Perfect and Wiles,

1994); and Q2, based on the widely used market-to-book ratio (Danbolt et al., 2002). Annual

depreciation is used to compute non-debt tax shield (Ndts). The market timing condition (Mktt)

variable is based on the market price per share. Two different variables are used for ownership

structure: Own which is the concentration of shares of the majority shareholder and Econgroup

which is a dummy variable that identifies the firm´s affiliation to a business group. This information

was obtained from the Chile’s Stock Market Supervisor, SVS. For the dividend policy (Div) we

used the pay-out ratio. We also include time dummies (Dummtemp) and industrial sector dummies

(Dummind) for each firm.

Additionally, we include the interaction of the growth opportunities with the firm size in its two

alternative measures (Q1*SizeI and Q2*SizeI) to test for the interacted impact of growth

opportunities as a function of firm size on the capital structure choice. The model to be tested takes

the following form:

Levit=β0+β1¿ ¿it+β2Profit+β3Tangit+β4Qit+β5Ndtsit+β6Mkttit+β7Ownit+β8¿it+β9Dummtempt+β10Dummindi+ηi+ηt+εit¿

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The error term is decomposed in ηi which represents the firm-specific effect of each firm i and

captures all time-invariant variables (e.g. managerial style, patterns of financial decisions, etc.); ηt

which is the temporal effect for the t periods considered in this study, and the stochastic error term

εit which varies both cross-sectionally and over time.

The model that considers these interacted variables takes the form of:

Levit=β0+β1Profit+β2Tangit+β3Qit+β4QitSizeIit+β5Ndtsit+β6Mkttit+β7¿it+β8OwnIit+β9Dummtempt+β10Dummindi+ηi+ηt+εit

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3.3. Methodology

Due to the panel structure of our data we estimate the models using the generalized method of

moments (GMM). The panel data methodology allows us to control for two typical problems in this

kind of study: unobservable heterogeneity and endogeneity problems (Arellano and Bover, 1990,

Lemmon et al., 2008). In fact, Arellano and Bover (1990) argue that panel data analysis also allows

measuring and identifying effects that are not observable with the cross-sectional or time-series

analyses.

The Hansen statistic is used for examining the lack of correlation between the instruments and the

error term. Wald-test of joint significance for all independent variables is computed as well as the

non-linear restrictions test for the interacted variables (see Table 4).

4. Results

4.1. Descriptive statistics

From Table 1 we can derive the following observations. First, approximately a 45.0% of the total

assets are financed with outstanding debt (Lev). The alternative variable (Lmv) suggests that

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studies for the Chilean corporate sector (Espinosa et al., 2012) and also from other economies

(Céspedes et al., 2010, Rajan and Zingales, 1995). Second, the pay-out ratio (Div) is relatively high

(55.3%). The mandatory pay-out ratio of at least 30% to protect the claims of minority shareholders

pushes up the average pay-out ratio beyond the legal requirements. Third, a typical firm has an

approximately 7.3% rate of return on total assets (Prof). Four, the two alternative proxies of growth

opportunities, Q1 and Q2, are higher than one (1.041 and 1.322 times), meaning that the market as a

whole has a general positive perception about a company’s future prospects. Five, about 48.0% of

outstanding shares are in the hands of the majority shareholder; something that is far higher than

what is needed to exercise control. Moreover, about 70.0% of firms in our sample are affiliated with

a business group. Finally, we also observe that the measure for the market timing condition (Mktt)

is positive (0.220 times), meaning positive growth in stock returns.

The correlation matrix is reported in Table 1. As expected, Lev and Lmv are highly correlated

(0.478). Statistics show that firm size (Size) plays an important role in driving financing decisions.

In fact, there is a positive relationship between the size of the firm and its debt level. Leverage

seems to be negatively correlated with future growth opportunities (Q1 and Q2), profitability (Prof),

pay-out ratio (Div), and the market timing condition (Mktt). However, a firm´s ownership structure

seems to be positively correlated with leverage.

[Insert Table 1 about here]

4.2. Multivariate analysis

Table 2 shows the regression results corresponding to equation (1) where the dependent variable is

Lev. Estimates show a positive and statistically significant relationship between firm size (Size) and

leverage. Firms of larger dimension are more diversified, are less likely to be in default, and are

able to use more efficiently the economies of scale in debt issuances which increase their debt

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Concerning profitability (Prof), our results support the pecking order theory. More profitable firms,

by default, have more internally generated resources, e.g. retained earnings, which allow them to

finance without external funds. Only once the internal funds are exhausted will the firm issue debt

and later, equity capital. This sequential financing decision supports the negative relationship found

between the firm’s profitability and leverage.

Collateral guarantee measured as tangibility of assets (Tang) does support our hypothesis which

indicates a negative relationship between the tangibility of assets and debt level. The explanation

for this negative relationship is consistent with theories based on information asymmetries and the

dynamics of the Chilean corporate sector (Denis and Mihov, 2003). Harris and Raviv (1991) argue

that the small information asymmetries associated with tangible assets allow equity to be less costly

than debt, driving a negative relationship between debt and tangibility. This negative relationship

seems to be particularly important in developing capital markets where information asymmetries are

a critical market friction in the allocation of resources. As a result, these signaling arguments seem

to support our findings in the Chilean corporate sector.

There is a negative and statistically significant relationship between growth opportunities –either

measured by Q1 or Q2, and leverage (Lev). It seems to be that it is harder to issue debt than equity

for financing growth opportunities. Additionally, since growth options represent strategic market

opportunities, firms might avoid sharing this source of strategic information with creditors by

financing the growth opportunities with internal sources instead of debt.

We find that firms try to reduce their tax burden by using non-debt tax shield (Ndts) instead of debt

itself, thereby avoiding distress and adjustment costs. Our hypothesis about a negative relationship

between non-debt tax shields and debt level is confirmed. The non-debt tax shield seems to be

particularly important whenever firms use an accelerated depreciation schedule, such as is the case

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Although we suggested that the market timing condition could be constrained as a consequence of

the legal restriction on stock repurchases in Chile, the findings are robust in showing a negative

relationship between stock returns (Mktt) and a firm’s leverage (Lev). Therefore, it seems to be that

Chilean firms take advantage of markets when stock prices go up by issuing equity and reducing

leverage.

The typical characteristics of the ownership structure in Chile addressed by a high concentration

and the active participation of a small number of controlling shareholders, as well as the firm

affiliation to a business group, allow companies to reduce efficiently the agency problems between

managers and shareholders. Our empirical results support this idea. The more concentrated the

ownership structure (Own), the higher leverage is, basically because better governed firms can issue

debt under more favorable contractual conditions. The firm´s affiliation to a certain economic group

or conglomerate (Econgroup) is also positively related with leverage. In this case, group-affiliated

firms have a higher average leverage than non-affiliated firms, which allows them to take advantage

of intragroup capital markets by both borrowing at the prevailing market interest rate (according to

the regulation) and having more flexibility in the negotiation of debt contracts with their

counterparties (Saona and Vallelado, 2005).

The pay-out ratio (Div) seems to be negatively correlated with debt according to our results in Table

2. This finding confirms our prediction supported by both the agency problem arguments and the

intrinsic characteristics of the regulatory system in Chile with regards to the protection of creditors’

rights. In this case, low dividend pay-out ratios serve as a substitute mechanism for weak creditor

rights protection. Consequently, creditors will impose restrictive covenants forcing managers to pay

low dividends in order to free up cash to pay back debt.

Finally, to check the robustness of our results, we consider the leverage at market value as an

alternative measure of the dependent variable (Lmv). In this case the results are qualitatively similar

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[Insert Tables 2 & 3 about here]

Subsequent results take into consideration the interacted variables of growth opportunities and firm

size. These results are tabulated in Table 4. For the first four regressions the dependent variable is

Lev, whilst for the other four regressions the dependent variable is Lmv. In this table we observe

that growth opportunities and firm size consistently drive debt decisions. Results show that Chilean

companies whose size exceeds the average firm size in our sample tend to increase the debt level as

their growth opportunities increase. This result is observed in the addition of the variables Q1 and

Q1*SizeI (Q1 + Q1*SizeI). As we can see in the table, the linear restriction test rejects the null

hypothesis that the coefficient of the addition of these two variables is equal to zero. Therefore,

large firms which account for growth opportunities prefer to issue debt to finance their growth

options. Apparently, growth opportunities of firms of larger dimensions are very sensitive to

information asymmetries. Larger firms will prefer to use debt instead of equity capital, for instance,

to finance growth. One argument which supports this finding is that the company might prevent the

dissemination of the informative content of growth opportunities by negotiating debt contracts

though private debt (e.g. banks). If additional equity capital is issued to finance future growth

opportunities, the company must release strategic information which may harm its competitiveness.

Additionally, larger firms may take advantage of economies of scale in issuing debt and use their

bargaining power to negotiate favorable debt contracts when growth opportunities need to be

funded.

The opposite finding is observed for small firms represented in the coefficient of Q1. Table 4 shows

that smaller firms tend to reduce their leverage as their growth opportunities increase. Smaller firms

are usually less mature businesses and have fewer chances to secure external sources of debt in

conditions as advantageous as larger firms do. It seems that the underinvestment and the asset

substitution problems for smaller firms are more plausible, and as a result their debt capacity is

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cost of debt is relatively higher for small than for large firms, it is more likely that small firms will

reject certain projects of comparable risk that would otherwise be accepted by larger firms.

Consequently, in the context defined by the presence of growth opportunities, our results show that

for smaller firms it is appropriate that they keep a low leverage (Jensen and Meckling, 1976, Goyal

et al., 2002).

[Insert Tables 4 about here]

5. Conclusions

According to various theories, the drivers of capital structure choice are still a black box. In this

work we attempt to shed some light on the determinants of capital structure for firms in an

institutional context that is often overlooked from empirical analyses: the Chilean corporate sector.

We have three primary findings.

First, the positive effect of firm size and ownership concentration as well as the negative effect of

growth opportunities, profitability, pay-out policy, the market timing condition, and non-debt tax

shields, have on firm leverage verify the postulates of the main theories on capital structure

decisions. The conclusions and expected relationships for certain variables in the Anglo-Saxon

context are also verified for the Chilean case.

Second, we observe some relations that are not in line with the current theoretical models on capital

structure. For instance, the negative relationship between the tangibility of assets and the level of

debt is justified by the existence of information asymmetries which compel firms with more (less)

information asymmetries to issue more (less) debt. Additionally, we conclude that the ownership

structure of Chilean firms as well as the formation of business groups allows them to reduce market

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Finally, our work contributes to capital structure puzzle literature in a number of ways. Our

approach enhances the dynamics on the capital structure puzzle because we consider the current

theoretical arguments as well as particular facts which are characteristic of the Chilean corporate

sector to build up our research hypotheses. Our major findings suggest that some of the insights

from modern finance theory are not necessarily transferable across countries, though much remains

to be done to understand the impact of different institutional features on capital structure choices.

This paper also contributes to the strategic decisions made by both practitioners and policy-makers.

Concerning practitioners, this work allows them to understand what factors drive debt choices.

Subsequently, knowing this dynamics, executives might take actions to add value for the companies

they manage. Regarding policy-makers, this study provides evidence that the current institutional

context requires better corporate governance legislation to better protect minority shareholders and

firm creditors. Despite statistics that place Chile at the top of other Latin-American countries in

terms of addressing market inefficiencies, institutional legislators and authorities must still consider

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Appendix

Independent variable

Leverage:

i) Lev=TDit

Eit

Where TDit is the total liabilities at the year t for the i firm, and Eit is the total common equity.

ii) Lmv= TDit

TDit+MkCptzit

Where MkCptzit is the market capitalization computed as the product among the year-end close price

per share Pit and the number of shares outstanding per firm i.

Independent Variables

Growth opportunities:

i) Q1=MkCptzit+TDit

Kit

TDit is the total liabilities at the year t; and Kit is the replacement value of the firm´s assets which is

estimated in Perfect and Wiles (1994) as follows:

Kit=RNPit+RINVit+(TAitBNPitBINVit)

Where RNPit is the replacement cost of net property, plant, and equipment (net fixed assets); RINVit is

the replacement value of inventories, TAit is the total assets; BNPit is the book value of net property,

plant, and equipment; and BINVit is the book value of inventories.

RNPit=RNPit1

[

1+ϕt

(20)

For t>t0 where t0 is the first year of observations for a given company in this study; whilst

RNPi t0=BNPi t0. Moreover, ϕt is the growth of capital good prices in year t which is defined by the

Gross Domestic Product (GDP) deflator. In other words, ϕt=NomGDPt

RealGDPt

100, where NomGDPt is the

nominal GDP and RealGDPt is the real GDP, both reported by the National Institute of Statistics of

Chile. δit is the real depreciation rate defined as δit= Depit

BNPit

, where Depitis the annual book

depreciation.

Iit is the new investment en property, plant, and equipment or capital expenditure which is defined as

Iit=BNPitBNPit1+Depit.

RINVit=BINVit

[

2WPIt

WPIt+WPIt1

]

Where WPIt is the wholesale price index reported by the National Institute of Statistics of Chile. This

estimation for the replacement value of inventories assumes that the inventory accounting method is at

average cost. For this method, the value of inventories reported at time t is approximately equal to the

average of the prices at t−1 and t.

ii)Q2=MkCptzit+TDit

TAit

Firm size: ¿ ¿it=ln(TAit)¿

Profitability: PROFit=EBTit

(21)

Where EBTit are the earnings before taxes.

Tangibility of assets: Tangit=BNPit

TAit

Dividends: ¿1it=

|

Dividendsit

¿it1

|

Where Dividendsit are the cash annual dividends and ¿it1 is the net income.

Ownership structure:

i) Ownit

Which represents the percentage of common shares held by the main shareholder.

ii) Econgroup

{

1if affiliated

¿ a business group¿0if standalone firm¿

Market timing condition:Mktt=Pit−1−Pit−2

Pit−2

We follow Baker and Wurgler (2002) for the measurement of this variable. It was estimated on the lags

of the t−1 and t−2 periods in order to prevent for the Welch (2004)´s inertia theory.

Non-debt tax shields:Ndts=Depit

(22)

Where Depit is the annual rate of depreciation.

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