Liquidity and capital structure: The case of Thailand

Abstract

We explore the impact of liquidity on capital structure decisions. Firms that enjoy more liquid equity experience a lower cost of equity and may be more motivated to adopt more equity and less debt in their capital structure. Consistent with this notion, the empirical evidence demonstrates an inverse relation between liquidity and leverage. Our results are especially interesting because we examine firms in Thailand, where capital markets are less sophisticated than the U.S., bank loans more prevalent, and corporate ownership much more concentrated. In spite of these differences, we document that Thai firms with more liquid equity are significantly less leveraged.

Introduction

Traditional capital structure theories have identified several determinants of capital structure choices such as size, growth opportunities, and profitability. Only until recently does liquidity receive attention from researchers as a potential determinant of capital structure decisions. The liquidity of a firm's equity is related to the ease with which a firm can raise external capital through a stock offering; less liquid stocks tend to have higher issuance costs and thus a higher cost of equity (Weston et al., 2005, Hennessy and Whited, 2005). Therefore, firms with more liquid equity are more motivated to issue equity than those with less liquid equity. As a result, capital structure choices are likely influenced by liquidity.

Consistent with this notion, two recent studies by Lipson and Mortal (2009) and Frieder and Martell (2006) document that firms with more liquid equity are significantly less leveraged. The results of both studies, however, are exclusively based on U.S. firms. It is not obvious whether or not these results can be extended to other countries where capital markets are less developed, corporate ownership much more concentrated and information asymmetry more severe. Our study is the first to investigate this issue in a non-U.S. economy.

As an emerging market, Thailand constitutes a distinctive setting for studying this issue. Due to the prevalence of bank loans, Thai firms rely less on capital market financing, potentially making liquidity less relevant in capital structure decisions. Public capital markets in Thailand are relatively young and not as developed as those in the U.S. In addition, several large Thai firms are part of a conglomerate that has its own commercial banks (Wiwattanakantang, 1999), which provide funding for firms in their business group. These characteristics make capital market financing less prevalent among Thai firms and may make the effect of liquidity on capital structure much less pronounced, if not disappear entirely. On the contrary, the corporate bond markets in Thailand are even less developed than the equity markets. Thai firms were not allowed to issue bonds until 1992. The less sophisticated bond markets may make issuing equity relatively more attractive and hence enhance the role of liquidity in capital structure decisions. Finally, corporate ownership is much more concentrated in Thailand than in the U.S. High ownership concentration has been shown to significantly affect liquidity.² For these reasons, it is not clear whether the results based on U.S. firms can be readily extended to firms outside the U.S. We fill this gap in the literature by investigating the impact of liquidity on capital structure choices in Thailand.³

Our empirical evidence reveals a significant association between liquidity and capital structure choices. In particular, we find that firms with more liquid equity hold less leverage. This is in agreement with the hypothesis that high liquidity lowers the cost of equity, hence providing incentives for firms to issue equity over debt. The association survives even after accounting for other determinants of leverage such as size, growth opportunities, non-debt tax shields, profitability, and industry and year effects. This evidence is in agreement with Lipson and Mortal (2009) and Frieder and Martell (2006). For robustness, we employ three alternative definitions of liquidity, namely Amihud's (2002) illiquidity, the modified turnover, and the modified liquidity ratio. All of these liquidity measures yield consistent results. The impact of liquidity on leverage is not only statistically significant, but also appears to be economically meaningful. For instance, when using Amihud's (2002) illiquidity to sort firms into quintiles, we find that the difference in leverage between the most liquid quintile and the least liquid quintile is 10% or more.

The results of our study contribute to the finance literature in several ways. First, we add to the literature in capital structure by showing that liquidity is a significant determinant of capital structure decisions. Extending Lipson and Mortal (2009), our study is the first to examine this issue using non-U.S. data. Second, the literature in market microstructure has examined the impact of liquidity on a number of variables. However, liquidity has hardly been investigated in the context of corporate finance. Our study is among the first to fuse market microstructure and corporate finance together. Third, the literature in emerging markets also benefits from our study. Emerging markets are typically characterized by severe information asymmetry, more acute agency costs, more corruption, and less developed financial markets. Our results show that, even in one such emerging market, the impact of liquidity on capital structure is significant. Finally, we contribute to the literature that examines capital structure decisions in foreign countries (Wiwattanakantang, 1999, Fan et al., 2008). Although capital structure choices in foreign countries may be motivated by factors that are different from those in the U.S., we show that liquidity remains a significant determinant of leverage in an emerging economy. This is especially interesting, considering that financial markets are much less liquid outside the U.S.

The remainder of this study proceeds as follows. Section 2 discusses the theoretical background and prior research. Section 3 presents the sample selection and describes the data. Section 4 displays and discusses the empirical results. Finally, Section 5 offers the concluding remarks.