SESSION 1A: Sectoral Analysis 23

Determinants of Capital Structure in the Construction Companies

across Europe and Central Asia Region
Asst. Prof. Dr. Hakan Bal (Beykent University, Turkey)
Abstract
This study examines the effects of asset tangibility, profitability, size and liquidity on capital structure (debt
leverage) across the construction companies operating in in Europe and Central Asia region using the data between
1993 and 2019. The study documents that the capital structure and other financial ratios under study differ across
countries, even in the same industry. Book leverage is found to be significantly negatively related to asset
tangibility, profitability and liquidity in accordance with pecking order theory. In particular, fixed ratio has a
negative effect on debt ratio in Russia and Romania, but no effect in other countries under study. The effect of size
disappears when time dummy variables are introduced.

1 Introduction
How and when firms choose external financing, or choose capital structure, is a heavily researched topic. Since
the discovery of the irrelevance of the capital structure on the firm value under perfect markets and absence of
taxes, researchers have investigated factors which may affect the capital structure decision.
Static tradeoff theory argues there are costs and benefits of debt. In particular, costs of debt include the direct
and indirect costs of bankruptcy, while the benefits include tax deductibility of interest expenses. By analyzing the
benefits and costs, firms choose an optimal leverage and try to maintain this ratio in their balance sheet. Assuming
insiders know more about the company than outsiders, pecking order theory argues firms prefer internal financing,
and when external financing is required, they choose debt over equity without any target or optimal leverage. The
two theories may give different predictions, which may yield testable hypotheses. For example highly profitable
firms would not need external financing, so would not raise debt according to pecking order theory. However,
according to tradeoff theory, for highly profitable firms, bankruptcy costs are lower, so they would have an
incentive to issue debt. Empirical studies find support for target leverage (Bradley, etal, 1984) and also support for
pecking order; a negative relation of profitability with market debt ratio (debt/market value of equity) (Titman and
Wessels, 1988).
Especially the studies on developing countries, the results of the studies have been less conclusive. The results
typically change with sectors and time period under investigation. Mismeasured variables pose a threat to the
validity of tests, the role of other stakeholders and supply side of capital should be investigated more (Graham and
Leary, 2011).
Construction sector is a particular sector, which requires large initial capital outlays, project life times and cash
payments are typically long term. This study examines the effects of asset tangibility, profitability, size and
liquidity on debt ratio for construction companies in Europe and Central Asia Region which mostly comprises of
developing countries. Asset tangibility, profitability and liquidity are found to be negatively associated with higher
leverage consistent with pecking order theory. Moreover, the negative relation between debt ratio and asset
tangibility comes from the companies in Russia and Romania.
The paper is organized as follows. Section 2 reviews the literature, Section 3 discusses the model and hypotheses,
Section 4 presents the data and descriptive statistics and Section 5 presents and discusses the results.

2 Literature Review
Under perfect capital markets and absence of taxes, it has been shown that debt ratio does not change the value
of the company (Modigliani and Miller, 1958). Static tradeoff theory emerged in which costs of debt, such as
bankruptcy, are balanced against benefits, such as tax shields associated interest payments provide, in order to
obtain an optimal debt structure (Kim, 1978) (Lee and Barker, 1977). In pecking order theory, firms prefer internal
financing to external financing, and in the latter, prefer issuing debt to equity, due to the information asymmetry
between owners and the market (Myers, 1984). Agency cost theory posits that firms may increase their debt to
reduce the free cash flow by increasing interest expense to alleviate the agency problem between owners and
managers (Jensen and Meckling, 1976). According to market timing theory, firms sell shares when they believe
the stock price is high, and engage in share buybacks when the stock price is low, and the effects of these actions
have persistent effects on the capital structure (Baker and Wurgler, 2002).
There is an extended literature on testing these theories empirically, with some shortcomings withstanding
(Graham and Leary, 2011). Based on the data between 1996 and 2004 on 15 EU countries on construction sector,
firm size is positively related to debt and market leverage. Asset utilization, profitability and risk (profit variability)
are negatively related, while liquidity and asset tangibility are not significantly related. Growth opportunities are
negatively related to book leverage but positively with market leverage (Feidakis and Rovolis, 2007).
24 INTERNATIONAL CONFERENCE ON EURASIAN ECONOMIES 2020

In UK companies between 1984 and 1996, profitability, liquidity and growth opportunities are found to be
negatively related to debt ratio, while size has no effect (Ozkan, 2001). Using the data on UK companies between
1989 and 1996, it is found that property asset intensity, development activities are positively, and trading activities
and size are negatively related to book leverage (Ooi, 1999).
Using the cross sectional data from France, Germany, Japan, the UK, and the US of 1992 or 1993, it has been
found that asset tangibility has a positive and profitability has a negative effect on leverage across all countries.
The effect of size is positive for US, UK and Japan but insignificant in Germany and France (Wald, 1999).
Cross industry studies, especially on construction sector, on capital structure are less numerous. In a cross
industry study based on US construction companies, market-to-book ratio, profitability and firm age are found to
be negatively related to leverage (measured as long term debt to assets), and firm size is positively related to
leverage (Talberg, et.al., 2008).
There are also studies on construction sector in developing markets. Construction sector differs from other
sectors in that the projects undertaken are usually long term and require significant capital outlays.
The evidence on the effects of firm variables on leverage is largely inconclusive in developing markets. Based
on the data between 2000 and 2010 of construction companies in South Korea, firm size has a positive effect while
profitability and asset tangibility negatively affects book leverage (Yoo, et.al., 2014). In Malaysia, based on the
data between 2001 and 2007, firm sales (proxy for size), asset tangibility and growth opportunities have positive
effect on leverage, while profitability has a negative effect on leverage (Baharuddin, et.al.,2011). Another study in
Malaysia using the data between 2005 and 2009 found profitability is positively related and asset growth is
negatively related to leverage (Ramezanalivaloujerdi, et.al., 2015). Between 2002 and 2011, on book leverage,
firm size has a negative effect in Russia, positive effect in India. Asset tangibility and firm size positively affects
leverage in India, while growth opportunities has a negative effect. In China, asset tangibility is found to have a
positive effect. The size and significance of these effects depend on the debt level of companies (Silva, et.al.,
2016). Based on the construction company data in Indonesian Stock Exchange between 2009 and 2014,
profitability increases the debt ratio (Gunardi, 2020). Asset tangibility is significantly negatively correlated with
book leverage on Omani listed construction companies (Al Ani and Al Amri, 2005). Profitability, liquidity and
asset tangibility are negatively, size and asset turnover are positively related to debt ratio in Romanian construction
companies (Serghiescu and Văidean, 2014). A study based on Slovenian firms between 1999 and 2006 finds asset
tangibility and profitability are negatively related to book leverage, while size is positively related (Črnigoj and
Mramor, 2009).

3 Model and Methodology

A fixed effect panel data model was employed as follows.

Depending on the postestimation tests performed, random effects and OLS were also employed where the
associated diagnostic tests of corresponding models failed.
The variables are book leverage (debt ratio=total liabilities/total assets), asset tangibility (fixed asset ratio=plant
property and equipment over total assets), profitability ratio (EBIT over TA), size (log(assets)), liquidity (current
ratio) and operating leverage (percentage change in EBIT over percentage change in sales). All of the variables
were computed using only balance sheet and income statement data. Fixed asset ratio, assets as well as liquidity
was transformed by log function, which will be explained in the later section.
From a tradeoff theory standpoint, fixed asset ratio is expected to positively affect leverage, as companies with
more fixed assets may find it easier to access debt. On the other hand, companies with higher fixed asset ratio have
lower cash, and thus lower agency costs. Therefore, they have less incentive to issue debt, from an agency cost
perspective. From a pecking order viewpoint, companies with more fixed assets than intangible assets may have
less information asymmetry between the owners and market, and may use more equity.
Highly profitable (EBIT/TA ratio) companies, according to tradeoff theory, will have more incentive to keep
higher levels of debt to utilize tax shields. Also, from the agency cost theory perspective, these companies have
more excess cash and has more incentive to reduce the excess cash through higher debt. From the pecking order
viewpoint, these companies have lower motives to seek external financing so their debt ratio would be lower.
According to tradeoff theory, larger (more assets) companies have more debt since these firms are typically more
diversified, so the bankruptcy risk is smaller, reducing the cost of debt. Since these companies are monitored more
by the market participants and regulatory authorities, there exists less information asymmetry between the owners
and managers. So, according to agency cost theory, they have less incentive to issue debt.
Companies with higher liquidity (current ratio) may have lower probability of bankruptcy or even may use
working capital to secure financing, thus lowering the cost of debt. So they have more incentive to take on debt
SESSION 1A: Sectoral Analysis 25

according to tradeoff theory. From an agency cost perspective, these companies have more cash. So, to solve the
agency problem between owners and managers, they have an incentive to take on more debt. From a pecking order
standpoint, they have more internal resources and thus have less incentive to seek outside resources, and thus have
lower debt.

4 Data
Corporate financial data of construction companies (listed and delisted) with assets more than 3 million USD in
Europe and Central Asia region was downloaded from EMIS Database. The data for which any of the variables
under study is missing was dropped. The final dataset contains 2607 company-year observations of 184 companies
from 16 countries from 1993 to 2019. The data is winsorized at 1% from both sides.
Table 1 shows the means of variables by country, and number of companies in each country. Financial ratios
differ across countries even if they are all in construction sector. Comparing Romanian construction companies
with other studies leverage is higher, fixed asset ratio is smaller, size is smaller (Serghiescu, L. and Văidean, 2014).
Book leverage is larger than reported in another study focusing on Russia, however this study focuses on
construction companies (Silva, et.al., 2016). The data on Poland are similar to another study which focuses on all
sectors.
No of No of obs Min year Max year Avg Debt Avg Avg Avg Log
comp. to asset Fixed Current EBIT/TA (Asts)
ratio Asset Ratio ratio
Ratio
Bulgaria 4 63 2001 2019 0.37 0.15 3.79 0.03 9.76
Croatia 6 97 1999 2019 0.65 0.35 1.08 -0.00 11.06
Estonia 2 6 2008 2016 0.19 0.01 13.93 0.02 11.02
Kazakhstan 1 9 2010 2018 0.20 0.75 1.97 0.10 14.72
Latvia 1 9 2007 2015 0.40 0.19 0.70 0.18 10.15
Lithuania 1 4 2006 2010 0.01 0.00 1.79 0.11 11.25
Moldova 1 2 2017 2018 0.46 0.54 1.06 0.00 8.66
Montenegro 1 2 2017 2018 0.08 0.32 8.39 -0.01 10.18
North Macedonia 4 41 2006 2019 0.49 0.25 1.28 0.01 10.73
Poland 81 1326 1993 2019 0.46 0.12 3.16 0.04 10.36
Romania 13 165 2005 2019 0.54 0.44 2.59 0.02 9.19
Russia 37 474 2001 2019 0.67 0.13 1.85 0.05 11.39
Serbia 2 25 2005 2018 0.54 0.30 1.32 0.07 9.04
Slovakia 8 149 1995 2019 0.45 0.33 2.55 0.04 9.73
Turkey 9 88 2005 2019 0.48 0.19 2.04 0.04 11.49
Ukraine 13 147 2001 2019 0.74 0.18 2.38 0.02 10.51
N 184 2607 1993 2019
Table 1. Descriptive Statistics by Countries Source: Author’s Own Calculations.
Table 2 shows the correlations between the variables. Debt to asset ratio is negatively correlated with fixed asset
ratio (asset tangibility), current ratio (liquidity), and EBIT/TA ratio (profitability), in accordance with pecking
order, but positively related to assets (size), in accordance with tradeoff theory. Other studies with developing
markets found similar correlations with respect to profitability and size of Oman companies (Al Ani and Al Amri,
2015), and size, fixed asset ratios, profitability and liquidity of South Korean companies (Choi, et.al., 2014).
Companies with higher fixed assets tend to have lower liquidity (current ratio), lower profitability (EBIT/TA) and
be smaller in size.
Debt to asset Fixed asset ratio Current ratio EBIT/TA Log
ratio ratio (asset)
Debt to asset ratio 1.00
Fixed asset ratio -0.03* 1.00
Current ratio -0.42*** -0.17*** 1.00
EBIT/TA ratio -0.04* -0.06*** -0.07*** 1.00
Log(asset) 0.20*** -0.26*** -0.04** -0.01 1.00
t statistics in parentheses * p<0.1, ** p<0.05, *** p<0.01
Table 2. Correlations of Variables Source: Author’s Own Calculations.
Table 3 shows the descriptive statistics of the variables under study. Debt to asset (leverage) ratios are similar to
other studies in developing countries; 0.60 in construction sectors in South Korea (Choi, et.al., 2014), 0.59-0.63
in Slovenia (Črnigoj and Mramor, 2009). The variables fixed asset ratio and current ratio has been transformed by
26 INTERNATIONAL CONFERENCE ON EURASIAN ECONOMIES 2020

natural log, as they exhibit a high degree of skewness. The transformed variables show better properties in terms
of range and skewness.
N Mean St.Dev. Min 25% 50% 75% Max
(Median)
Debt to asset ratio 2607 0.52 0.26 0.01 0.33 0.54 0.72 0.98
Fixed asset ratio 2607 0.18 0.21 0.00 0.01 0.10 0.27 0.82
Log(Fixed asset 2607 0.15 0.16 0.00 0.01 0.10 0.24 0.60
ratio)
EBIT/TA ratio 2607 0.04 0.09 -0.26 -0.00 0.03 0.08 0.37
Log(asset) 2607 10.50 1.74 6.66 9.21 10.49 11.68 15.00
Current ratio 2607 2.67 4.64 0.04 1.02 1.39 2.34 32.32
Log(Current ratio) 2607 1.03 0.60 0.04 0.70 0.87 1.21 3.51
Observations 2607
Table 3. Descriptive Statistics Source: Author’s Own Calculations.

5 Results
Table 4 shows the results of the regressions. Columns (1) to (3) show results without time dummy variables, and
columns (4) to (6) show results with time dummy variables. Based on the diagnostic tests shown, model (6) passes
the diagnostic tests. Other regressions results are displayed, since by using fixed effects in (6) cross country
variation in leverages would be omitted, and the results are the same without the fixed effects.
In all specifications, debt ratio is negatively related to fixed asset ratio (asset tangibility), EBIT/TA ratio
(profitability) and log of current ratio (liquidity), but positively related to size. The results are consistent with the
findings in the literature for construction companies (Yoo, et.al., 2014) and Slovenia (Črnigoj and Mramor, 2009),
but not studies on Malaysia (Baharuddin, et.al.,2011) (Ramezanalivaloujerdi, et.al., 2015), India and China (Silva,
et.al., 2016).
These results are largely consistent with Pecking Order framework, except size. Similar conclusion are reached
by a study on Polish companies (Mazur, 2007). In Table 4, in the regression with time dummies (6) size loses
significance, and time effects are significant. This shows it is important to add time covariates into leverage
regressions (Feidakis and Rovolis, 2007) (Gunardi, et.al.,2020).
Dependent variable
Debt to asset ratio (1) (2) (3) (4) (5) (6)
Log(Fixed asset ratio) -0.17*** -0.14** -0.14** -0.19*** -0.16** -0.16**
(0.03) (0.06) (0.07) (0.03) (0.06) (0.07)
EBIT/TA ratio -0.12*** -0.23*** -0.24*** -0.12** -0.23*** -0.25***
(0.05) (0.06) (0.06) (0.05) (0.06) (0.07)
Log(Asset) 0.02*** 0.02** 0.01* 0.02*** 0.02** 0.02
(0.00) (0.01) (0.01) (0.00) (0.01) (0.01)
Log(Current ratio) -0.24*** -0.17*** -0.16*** -0.25*** -0.17*** -0.16***
(0.01) (0.02) (0.02) (0.01) (0.02) (0.02)
Company effects No Yes (re) Yes (fe) No Yes (re) Yes (fe)
Time dummy vars No No No Yes Yes Yes
Observations 2607 2607 2607 2607 2607 2607
R2 0.35 0.20 0.37 0.21
Adjusted R2 0.35 0.20 0.36 0.20
F 351.59*** 25.11 49.88
N (groups) 184 184 184 184
Hausmann test stat 46.33*** 108.71***
(df) (4) (30)
Wald test for heterosce. 1.6e+33*** 1.0e+33***
(df) (184) (184)
Breusch Pagan LM test for 2463.84*** 2194.96***
random effects
Joint test for time effects 2.60*** 263.04*** 7.45***
(df1,df2) or (df) (26,2576) (26) (26,183)
Robust standard errors in parentheses * p<0.1, ** p<0.05, *** p<0.01

Table 4. Regression Results of Debt to Assets Ratio Source: Author’s Own Calculations
Table 5 shows the separate regression results for the largest countries in the sample. For each country different
methods were used as suggested by the diagnostic tests. In particular, as the number of groups in countries drop,
it became harder to estimate time dummy variables under heteroscedasticity.
SESSION 1A: Sectoral Analysis 27

In Table 5, Russia and Romania are the countries where fixed asset ratio negatively affects the debt ratio, while
in other countries the effect is statistically insignificant. This is consistent with the OLS regressions of the Romania
study (Serghiescu and Văidean, 2014), but not with the study on Russia (Silva, et.al., 2016). This may be due to
Russian and Romanian construction companies utilizing more fixed assets (median fixed asset ratios are 9% and
44% respectively) compared to other countries like Poland (4%).
Profitability (EBIT/TA ratio) loses significance in Russia, Romania and Turkey. Also, liquidity (current ratio) is
negatively related to debt ratio in all countries except Romania. These two results may be due to reduced sample
size.
Dependent variable Poland Russia Romania Turkey Others
Debt to asset ratio (1) (2) (3) (4) (5)
Log(Fixed asset ratio) 0.04 -0.34*** -0.58*** -0.18 -0.23
(0.09) (0.12) (0.16) (0.14) (0.22)
EBIT/TA ratio -0.18** -0.19 -0.30 0.04 -0.39*
(0.08) (0.13) (0.25) (0.09) (0.23)
Log(Asset) 0.02 0.02 -0.10 0.03** 0.01
(0.01) (0.02) (0.07) (0.01) (0.02)
Log(Current ratio) -0.16*** -0.21*** -0.10 -0.35*** -0.08***
(0.02) (0.05) (0.06) (0.09) (0.03)
Company effects Yes (fe) Yes (re) Yes (re) No Yes (fe)
Time fixed effects No No No No No
Observations 1326 474 165 88 466
R2 0.25 0.28 0.18 0.29 0.19
Adjusted R2 0.25 0.28 0.16 0.25 0.18
F 16.84 15.81 10.02 21.25 5.40
N groups 81 37 13 9 41
Robust standard errors in parentheses * p<0.1, ** p<0.05, *** p<0.01

Table 5. Regression Results of Debt to Assets Ratio by Countries Source: Author’s Own Calculations.

6 Conclusion
In this study, the effects of asset tangibility (fixed asset ratio), profitability (EBIT to total assets), size (assets)
and liquidity (current ratio) on capital structure are examined for the listed and delisted construction companies in
European and Central Asian region.
Debt ratio is significantly negatively related to asset tangibility, profitability and liquidity. The significance of
size drops when time dummies are introduced, which shows the importance of adding time varying covariates.
The results provide support for pecking order theory of capital structure.
Country-wise regressions show that negative effect of asset tangibility arise from Russia and Romania, while it
is not present in Poland and other countries.
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