UNIVERSITEIT GENT FACULTEIT ECONOMIE EN BEDRIJFSKUNDE ACADEMIEJAAR 2008 – 2009 The effect of notional interest deduction on the financing policy of SMEs Masterproef voorgedragen tot het bekomen van de graad van Master in de Toegepaste Economische Wetenschappen Sofie Cornelis Steffie Merckx onder leiding van Prof. Dr. Philippe Van Cauwenberge
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UNIVERSITEIT GENT
FACULTEIT ECONOMIE EN BEDRIJFSKUNDE
ACADEMIEJAAR 2008 – 2009
The effect of notional interest deduction on the financing policy of SMEs
Masterproef voorgedragen tot het bekomen van de graad van
Master in de Toegepaste Economische Wetenschappen
Sofie Cornelis
Steffie Merckx
onder leiding van
Prof. Dr. Philippe Van Cauwenberge
UNIVERSITEIT GENT
FACULTEIT ECONOMIE EN BEDRIJFSKUNDE
ACADEMIEJAAR 2008 – 2009
The effect of notional interest deduction on the financing policy of SMEs
Masterproef voorgedragen tot het bekomen van de graad van
Master in de Toegepaste Economische Wetenschappen
Sofie Cornelis
Steffie Merckx
onder leiding van
Prof. Dr. Philippe Van Cauwenberge
PERMISSION
Ondergetekenden verklaren dat de inhoud van deze masterproef mag geraadpleegd en/of
gereproduceerd worden, mits bronvermelding.
Sofie Cornelis
Steffie Merckx
The effect of notional interest deduction on the financing policy of SMEs I
PREFACE
Writing this master thesis after a four-year education in applied business economics feels like
fitting the final piece of a giant puzzle. A lot of effort was necessary. However, looking back
to the result gives much satisfaction in return.
There are some people we would like to thank for their support. First, we owe many thanks to
our promoter Prof. Dr. Philippe Van Cauwenberge for his time, guidance and critical
reflections. Next, we are grateful to Katrien Kestens and Kelly De Brabanter for their
assistance and useful advice.
Furthermore, we thank our life partner and our family for giving us their moral support.
May 2009,
Sofie Cornelis
Steffie Merckx
The effect of notional interest deduction on the financing policy of SMEs II
TABLE OF CONTENTS
PREFACE ....................................................................................................................................... I
TABLE OF CONTENTS .................................................................................................................. II
LIST OF ABBREVIATIONS ............................................................................................................ III
LIST OF TABLES ......................................................................................................................... IV
LIST OF FIGURES ........................................................................................................................ IV
Notes: t = 2007. N is the number of observations. ***: denotes statistical significance at the 1% level respectively (two tailed). Each variable has been deflated by the total of assets of the corresponding year. Variable definitions are given in Appendix A.
The effect of notional interest deduction on the financing policy of SMEs 28
Ultimately, we assess in Table 11 the Pearson correlations among leverage and other firm
characteristics we will use later on as respectively the dependent and explanatory variables in
our multivariate analysis. Leverage is positively correlated with MTRt-1 (incl. NID) and
tangibility, while negatively correlated with profitability. However, there does not seem to be
a significant correlation between leverage on the one hand and investments, growth
opportunities, size and dividend payout on the other hand. The positive correlation between
leverage and MTRt-1 (incl. NID) points out that firms with higher tax incentives are more
levered or vice versa. Finally, the correlations between size and other explanatory variables
indicate that larger firms have a lower MTR, lower profitability, a higher proportion of
Notes: t = 2007. N is the number of observations. ***, **, * : denotes statistical significance of the correlation at the 1%, 5%, 10% level respectively (2-tailed).
4.3. Multivariate analysis
In this section, it is our aim to empirically investigate the significance, nature and extent to
which notional interest deduction has an influence on capital structure while taking into
account other determinants known in finance and accounting literature. Focusing on the year
2007, we use cross-sectional data to run OLS regressions of 4 dependent variables namely
leverage, the change in leverage, the long-term debt ratio and the financial debt ratio.
However, before we introduce any regression equation, it is necessary to first consider an
appropriate functional form. Empirical studies of capital structure mostly use either leverage
or gearing as a measure for the level of debt. Given their formula, both measures are
constrained within a certain range of values. For companies with non-negative equity,
The effect of notional interest deduction on the financing policy of SMEs 29
leverage (i.e. debt/(debt + equity) ) is limited between zero and one while gearing (i.e.
debt/equity) only delivers values from zero to infinity. Unfortunately, the use of these
bounded variables as a dependent variable in a linear regression model will not guarantee
estimates of the regressand that meet those restrictions. An econometrical problem occurs
since estimates beyond the limits of leverage resp. gearing are useless. In addition, the
goodness of fit of the regression model (R²) will not be as high either. Nevertheless, the issue
can be dealt with by using a logistical transformation of leverage (Jordan, Lowe & Taylor,
1998).
As estimates of leverage can only exist within the range of zero to one, the relationship
between leverage and its set of linearly related explanatory variables is rather described by the
cumulative logistic distribution function:
Leverage 1
1 + e-(0 + 1 X1 + … + )
The logistical transformation of leverage is then a linear function of the set of explanatory
variables:
Ln Leverage
= 0 + 1 X1 + … + 1 - Leverage
This equation can be rewritten as:
Ln Debt
= 0 + 1 X1 + … + Equity
where ln(debt/equity) denotes a logarithmic transformation of gearing.
The logistical transformation of leverage turns out to be equal to a logarithmic transformation
of gearing which is an unbounded measure. When leverage moves from zero to one and
gearing varies from zero to +, the natural logarithm of gearing reaches from - to +.
The use of the natural logarithm of gearing as a dependent variable consequently solves the
econometrical issue concerning bounded variables.
As our other dependent variables also have two boundaries, we will subject them to the same
logistical transformation which results in the following formulation: the change in the natural
logarithm of gearing, the natural logarithm of the long-term to short-term debt ratio and the
natural logarithm of the financial to non financial debt ratio.
The effect of notional interest deduction on the financing policy of SMEs 30
Finally, we remark that the logistical transformation of the dependent variables does not have
any impact on the interpretation of our results. We merely apply the transformation to solve
an econometrical issue. A significant positive resp. negative impact of any explanatory
variable on, for instance, the natural logarithm of gearing can still be interpreted as a positive
resp. negative impact on leverage, given that gearing is positively related to leverage. Our
hypothesis thus remains:
Notional interest deduction has a negative influence on leverage (H1).
4.3.1. General model
Although a lot of previous research has been done about the determinants of capital structure,
this is the first study which examines the effect of notional interest deduction. As indicated in
section 3.4, we expect notional interest deduction to have a negative influence on leverage.
We include the marginal tax rate in a multivariate regression to assess the effect of notional
interest deduction on a companies tax incentives while ln(gearing) will serve as a measure for
leverage. To control for other factors which could simultaneously influence leverage, we will
also take into account the most important determinants already found in literature.
First, the pecking order theory predicts more profitable firms to be less levered than less
profitable firms because the more profitable firms can rely on a higher level of internal
resources to fund investments. Additionally, the same theory asserts high growth firms to be
more levered since they need higher levels of funding compared to other firms which grow
slower. As existing research contains evidence that SMEs exhibit strong pecking order
behaviour, we expect profitability and investments to be negatively resp. positively related to
leverage. Whereas theory clearly indicates the determinants, there is however a lot of
controversy in the literature about how to measure these concepts. We chose EBIT to total
assets as a measure for profitability in order to capture the operational result which gives a
more robust indication for the profitability of a companies business. To measure the level of
investments it is necessary to correct the value of total assets in a given year for all
depreciations, impairment losses and revaluations on new and existing assets to make the
amount comparable to the value of total assets in the previous year. We consider an increase
in total assets as an investment of money, while a decrease represents the opposite.
The effect of notional interest deduction on the financing policy of SMEs 31
Consistent with the trade-off theory, we include size as another control variable. Size is often
used as an inverse proxy for default because smaller firms tend to be less diversified and
therefore carry a higher operating risk. We will measure size as the natural logarithm of total
assets.
According to the underinvestment problem of the agency theory, firms with high growth
opportunities will be less levered than other firms. We measure growth opportunities as the
ratio of intangible assets to total assets of the firm. The agency theory also indicates that firms
with relatively more tangible assets will be more levered as they have easier access to finance.
The higher liquidation value of this type of firms and the possibility for creditors to demand a
collateral will reduce adverse selection and moral hazard. We will use the ratio of fixed
tangible assets to total assets as a proxy for tangibility. The theory further predicts that the
amount of dividends paid will be negatively related to leverage, as dividends and leverage are
used as substitutes to control free cash flow problems. We define dividend payout as the ratio
of dividends to total assets. Finally, we include seven dummies in each regression model to
control for industry effects. Appendix A summarizes the definition of the variables we use.
Appendix B gives an overview of the empirical predictions by the main theories and their
outcomes concerning the explanatory variables.
Before we proceed to the discussion of our general regression model, we first investigate the
effect of the several control variables on leverage. The OLS regression equation of the natural
Notes: t = 2007. Model 3 differs from model 2 only by the substitution of MTRt-1 (incl. NID) by MTRt-1 (excl. NID) and MTRt-1 (incl.- excl.). In this way, model 3 makes the effect of notional interest deduction explicit. T-statistics are displayed in parentheses below the Bèta-coefficients. P-values are given in italics. ***, **, * : denotes statistical significance at the 1%, 5%, 10% level respectively. All OLS regressions include seven industry dummies. The coefficients on these dummies are not reported. Variable definitions are given in Appendix A.
The effect of notional interest deduction on the financing policy of SMEs 33
less debt when financing their activities. As expected, investments and leverage are found to
be positively connected although not significantly, whereas growth opportunities is positively
related to leverage but only significant at the 10% level. This latter result does not support the
prediction of the agency theory but is consistent with other research. As SMEs mainly use
short-term debt financing, the negative effect of growth opportunities on long-term lending
will be dominated by an increase in the use of short-term debt. Size is negatively related to
leverage, contrary to the expected positive relationship by the trade-off theory. As access to
long-term debt is often restricted by lenders to small businesses, it is especially long-term
debt that is positively related to firm size (Sogorb-Mira, 2005). Small companies will
compensate this restriction by using relatively more short-term debt. In that case, the negative
effect of size on short-term debt can outweigh the positive effect of size on long-term debt.
Consistent with the prediction of the agency theory, we find that tangibility is positively
related to leverage. We can accept there is evidence that assets with a high collateral value
help to reduce problems of adverse selection and moral hazard. Finally, the results show that
dividend payout has a positive impact on leverage, which is in contrast with our expectations.
This outcome could be explained by Myers (1984) who states that dividends are for unknown
reasons sticky in the short term. Since financing costs are higher for equity than for debt, the
pecking order theory expects leverage to respond strongly to short-term variation in earnings
and investment. Fama and French (2002) provide confirming evidence.
Next, we include the marginal tax rate in our regression analysis. By means of the following
equation we investigate whether the marginal tax rate which includes the effect of notional
interest deduction has a significant influence on leverage:
Notes: t = 2007. Model 5 differs from model 4 only by the substitution of MTRt-1 (incl. NID) by MTRt-1 (excl. NID) and MTRt-1 (incl.- excl.). In this way, model 5 makes the effect of notional interest deduction explicit. T-statistics are displayed in parentheses the below Bèta-coefficients. P-values are given in italics. ***, **, * : denotes statistical significance at the 1%, 5%, 10% level respectively. All OLS regressions include seven industry dummies. The coefficients on these dummies are not reported. Variable definitions are given in Appendix A.
The effect of notional interest deduction on the financing policy of SMEs 37
significant influence from the change in marginal tax rate is found on the change in leverage
since the introduction of the notional interest tax deductibility. This while the change in
profitability, investments and dividend payout do have a significant influence.
On the other hand, as we assumed special media attention to the deductibility of notional
interest, we run the same regression in differences as in model (4) but with the effect of
notional interest on the marginal tax rate made explicit in model (5):
Notes: t = 2007. Models 7 and 9 differ from models 6 and 8 only by the substitution of MTRt-1 (incl. NID) by MTRt-1 (excl. NID) and MTRt-1
(incl.- excl.). In this way, the models 7 and 9 make the effect of notional interest deduction explicit. T-statistics are displayed in parentheses below the Bèta-coefficients. P-values are given in italics. ***, **, * : denotes statistical significance at the 1%, 5%, 10% level respectively. All OLS regressions include seven industry dummies. The coefficients on these dummies are not reported. Variable definitions are given in Appendix A.
The effect of notional interest deduction on the financing policy of SMEs 40
are the same. We conclude that the notional interest deduction, embodied by the change in the
marginal tax rate, negatively influences the proportion of long-term debt to total debt. Again,
the change in future tax advantages caused by notional interest deduction seems to be of
greater importance for leverage than a change that would be caused by other determinants of
the marginal tax rate. Regarding the control variables, profitability, investments and dividend
payout carry a negative sign while size and tangibility carry a positive sign. Once again,
growth opportunities does not have a statistically significant impact on the long-term debt
ratio.
Next, we investigate the existence and direction of a significant impact of notional interest
deduction on the proportion of financial debt. As we regard financial debt as being more
adaptable when converting to a desired capital structure, we expect to find a negative impact
of notional interest deduction, which is measured by use of the marginal tax rate.
Nevertheless, no significant results are found in both model (8) and model (9) (cfr. Table 14).
Finally, we recognize that also in this subsection some multicollinearity arises between the
marginal tax rate variables in models (7) and (9). Although the VIF values are far lower than
in model (3), MTRt-1 (excl.NID) and MTRt-1 (incl.- excl.) show values of 13 and 12
respectively (not reported) for the regression of long-term debt, and values of 11 and 10
respectively (not reported) for the regression of financial debt.
The effect of notional interest deduction on the financing policy of SMEs 41
5. Conclusions
This paper investigates the effect of the notional interest deduction on the capital structure of
small and medium sized enterprises. The notional interest deduction is an extra fictitious
deduction on the taxable income, which should partially compensate the firm‟s fiscal
advantage on debt financing. We illustrated through examples that, when everything else
remains equal, the marginal tax rate will be lower after the introduction of notional interest
deduction. Thus, since the marginal tax rate serves as a proxy for the tax incentives that firms
experience under the trade-off theory, we assess whether leverage decisions are affected by
the change in marginal tax rates. In order to include these marginal tax rates in a regression
model, we first simulate them by making use of Graham‟s method. To isolate the individual
effect of tax incentives, we control for the most important determinants found in literature,
which are profitability, investments, growth opportunities, size, tangibility and dividend
payout.
We can present two major findings. First, it appears that the capital structure of SMEs is also
determined by the notional interest deduction. The bigger the companies decrease in marginal
tax rate caused by notional interest deduction, the smaller the companies proportion of debt in
the subsequent reporting period. We also find evidence that a decrease in the marginal tax rate
caused by notional interest deduction will have a greater impact on leverage than a decrease in
the marginal tax rate caused by other factors. Second, we observe a significant and positive
contribution of the change in a companies marginal tax rate caused by notional interest
deduction to the change in leverage over the past two years.
These findings support our hypothesis that the notional interest deduction has a negative
influence on leverage. In addition, we can conclude that the notional interest deduction,
embodied by the marginal tax rate, negatively influences the proportion of long-term debt to
total debt.
In summary, the findings of the research in our paper confirm the prediction that the
introduction of notional interest has caused a decrease in marginal tax rates, and consequently
an increase in the proportion of a companies equity. Additionally, the results generally
support static trade-off and pecking order arguments concerning the control variables.
The effect of notional interest deduction on the financing policy of SMEs 42
In order to have the most detailed information available, we did not include in our sample the
firms that report their financial statements through an abbreviated format. When these firms
are significantly smaller than the firms which report through a complete format, our findings
will be only generalizable for bigger SMEs.
Our regression model assumes that a companies capital structure is situated at an optimal
level every year. Literature (Flannery & Rangan, 2006) has already indicated that this is not the
case in reality. Companies do not convert immediately and completely toward a new target
structure when there is a significant change in its determinants. On the contrary, they only
partially change their level of debt due to transaction costs. In other words, the capital
structure will be also determined by historic debt levels. We therefore recognize the lack of
dynamics in our approach as a limitation to this research.
As this research only uses secondary information from financial statements, we do not know
for sure whether the companies in our sample actually deduct a notional interest from their
taxable income. Companies that satisfy the definition of SME according to article 15, §1 of
the Code of Companies have to chose between either a deduction of notional interest or a
deduction for newly invested assets. A lot of factors will influence this decision. For example,
companies with a relatively low equity will rather chose a deduction for investments. The
leverage of these companies will therefore not react to the introduction of notional interest as
they do not make use of it. This limitation creates opportunities for further research.
Furthermore, within the scope of a partial adjustment of capital structures, it will be
interesting to investigate the impact of notional interest deduction in the coming years. Any
contribution of the subprime crisis can then be studied as well.
The effect of notional interest deduction on the financing policy of SMEs V
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A&T Partners, Forceville M., 2008, De notionele intrestaftrek - een stand van zaken, URL:
Growth Opportunitiest-1 Intangible Assetst-1 / Total Assetst-1 |21| / |20/58|
Sizet-1 Ln (Total Assetst-1 / 1000) |20/58|
Tangibilityt-1 Fixed Tangible Assetst-1 / Total Assetst-1 |22/27| / |20/58|
Dividend Payoutt-1 Dividendst-1 / Total Assetst-1 |694| / |10/49|
Aget-1 Age of the firm at the time since date of incorporation
Average Workforcet-1 Average number of people who are employed within the company
Turnovert-1 Ratio of annual sales to inventory |70|
The effect of notional interest deduction on the financing policy of SMEs X
Appendix B: Empirical predictions by the main theories and their outcomes concerning the determinants of capital structure in SME financing
Variable Theory Effects on Capital Structure
Expected
Relation
Relation in
previous
research
Actual
Relation
Marginal tax rate Trade-off theory Firms which pay more taxes will have higher optimal debt levels + + +
Profitability Pecking order theory More profitable firms will need less debt - - -
Trade-off theory More profitable firms will have higher optimal debt levels +
Investments Pecking order theory Firms with more investments will need more debt + + +
Agency theory Firms with more profitable investments will have a lower level of debt -
Growth opportunities Agency theory Firms with greater growth opportunities will be less levered - + +
Agency theory Firms with greater growth opportunities will have less long-term debt - + -
Size Trade-off theory Smaller firms will have lower optimal debt levels + + -
Tangibility Agency theory Firms with a high proportion of tangible assets will be more levered + (no consensus) +
Dividend Payout Agency theory Firms with a high payout ratio will be less levered - - (not significant) +
Notes: The expected relation refers to the relevant theory and shows the expected sign of the coefficient in a regression. The relation in previous research indicates the sign that other researchers
have found. The actual relation denotes the sign of the coefficient in the outcomes of our study.