CHAPTER 3

DETERMINANTS OF CAPITAL STRUCTURE IN FAMILY

FIRMS: A CONCEPTUAL FRAMEWORK AND
HYPHOTHESES BUILDING

3.1. Introduction

With the aim of establishing the theoretical basis of this thesis, this chapter synthesises
the literature on family firms grounded in agency and stewardship theories. The dynamic
perspectives of both theories that are informed by family-centred noneconomic goals, as
a basis for decision-making in family firms, are presented. Since the founder established
the family business, he or she would value the business more prior to his/her ownership.
However, the situation can be very different once the business passes to the next
generation. In the corridor to preserve SEW, capital structure-related decision can be a
channel through which control-motivated family firms can defend their businesses via
control and involvement. In this chapter, the approaches of determinants of capital
structure generally, as well as the role of capital structure in family firms and their
consequences, are emphasised. My focus then narrows to the more specific determinants
of capital structure in family firms. In doing so, this study establishes a theoretical
framework for testing the influence of SEW dimensions on capital structure and
controlled by firm characteristics variables in order to yield interconnection between
family firms and capital structure decisions.

3.2. The Theory of Capital Structure

3.2.1. Determinants of Capital Structure

Capital structure decisions in the context of family firms will be informed by the two
grounded theories of family firms: agency and stewardship. Those two theories offer a
prominent perspective to examine issues related to agency problems. The theories
highlight the issues of interest, motivation and compliance (Donaldson, 1990) that

49
together direct the actual behaviour of agents, as well as governing managers to take
decisions. Thus, I will start with the forces that determine capital structure: agency,
control and asymmetrical information. In a family firm the decisions regarding debt level
may a function of those forces to drive such as the need for control, risk preference, and
family’s goals. The integration of primary determinants of corporate policies: behavioural
preferences of managers and a firm’s characteristics may yield interconnections for
understanding the determinants of family firms’ capital structures.

Haris and Raviv (1991) have identified four categories of determinants of capital structure
that are based on the forces that determine capital structure. From the four categories I
will prioritise three aspects that are relevant to explaining the capital structure decisions
in family firms: i) the agency approach, ii) the control approach and iii) the asymmetric
information approach. These three factors have identified the potential determinants of
capital structure. Following these forces, I will start with the general idea of determinants
of capital structure, and will then develop a model whose main focus is on family
business.

3.2.1.1. The Agency Approach

This approach focuses on the conflict of interests among various parties with claims to
the firm’s resources. Agency cost models predict that a firm’s equity ownership structure
affects the manager-principal agency conflict. This conflict is because the manager may
own less than 100 percent of the firm’s shares or managers may make decisions that
conflict with the best interests of the shareholders (Harris and Raviv, 1988; Jensen and
Meckling, 1976). However, the classic agency researchers have only concentrated on the
agent side in this agency problem. It should be noted that the problem may also happen
from the side of principal who can exploit the agents (Perrow, 1986). From the
perspective of a principal, reducing the inefficiency of managers can be done by
increasing the fraction of managerial ownership or increasing the fraction of the firm’s
finance by debt. Since debt commits the firm to pay out cash, it can be supposed that debt
will reduce the amount of free cash available to managers to engage in their personal
pursuits by honouring interest payment obligation (Jensen, 1986). However, Moh’d et al.
(1998) found that the dominant principal is associated with lower debt ratios, suggesting
that the presence of a dominant principal might substitute for the disciplinary role of debt

50
in capital structure. Such principals are supposed to monitor managers intensively without
enhancing mechanism to reduce agency problems.

Under the agency approach, managers are assumed to always want to invest all available
funds, even if paying out cash is better for investors. This investment related issue can be
the source of conflict when principals and creditors do not have information regarding
the investment; whether it is a good opportunity or a poor option. Stulz (1991) and Jensen
(1986) posit that the abundance of good investment opportunities will create an over-
investment problem between managers and principals. Hence, managers may substitute
higher quality projects with lower quality project to get favourable terms from creditors.
Thus, after loan funding, managers can use the proceeds from risky projects, then passing
the unforeseen risk to creditors. In other words, managers make risky decisions to
maximise shareholders’ value at the expense creditors’ interests. This problem highlights
the conflict between shareholders and creditors because creditors have a claim on a firm’s
assets in the situation of bankruptcy. On the other hand, shareholders have control over a
manager’s decisions affecting a firm’s riskiness. Therefore, debt can mitigate the problem
by giving creditors the option to force liquidation if cash flows are poor, meanwhile at
the same time use debt as a mechanism of shareholders to monitor manager’s risky
behaviour. Firms with higher liquidation values, such those with high tangibility assets
and a non-debt tax shield, will have more debt and will be more likely to default but will
have higher market value than firms with lower liquidation values (Harris and Raviv,
1990). Thus, a higher leverage can be expected to be associated with a large firm size, a
large debt level relative to expected firm income, and a lower probability of restructuring
following default.

However, from the side of managers, the agents as a main component of principal-agents
relationship, their performances mostly depend on their abilities, motives and
opportunities. Several researchers suggest that classic agency theory only emphasises
agency costs and alignment issues as a prescription to minimise agency problems without
concern for managers’ risk preferences, time dimension and their motives (Wiseman and
Gomez-Mejia, 1998; Sanders and Carpenter, 2003; Pepper and Gore, 2012). The ways
that managers may work for the best interests of firms, and may act as a steward for the
firms, is not included in the factors that can shape the principal-managers relationship.
Managers may view that debt is a stable monitoring mechanism by the same shareholders
since using debt is preferred by incumbent shareholders. Thus, managers may think that
51
they have to maintain the continuous alignment with incumbent shareholders and act in
the shareholders’ best interests.

Combining these results, agency models propose that an optimal capital structure can be
obtained by trading off the agency cost of debt, such as asset substitution, bankruptcy cost
and underinvestment, against the benefits of debt, such as increased managerial
ownership and reduced free cash flows. In particular these models predict that leverage
is positively associated with a default probability (Harris and Raviv, 1990), liquidation
value (Williamson, 1988; Harris and Raviv, 1990), free cash flows (Jensen, 1986).
Leverage also relates to the extent to which the firm is seen as a takeover target by
creditors and its managerial reputation (Hirshleifer and Thakor, 1989). However, leverage
is expected to be negatively associated with growth opportunities (Jensen and Meckling,
1976; Stulz, 1990), interest coverage and the probability of restructuring following
default (Harris and Raviv, 1990). Since default is a threat to the firm’s sustainability,
managers may limit the benefit from using more debt, with risk avoidance becoming a
dominant drive to reduce debt levels.

Admittedly agency model has offered a prediction about the determinants of capital
structure, but in my account this approach has limitations due to the time dimension. This
issue relates to the limited or unlimited alignment between principal-manager where the
future is uncertain. The role of principal is only limited to monitoring managers;
meanwhile managers are not always opportunistic and incompetent, and therefore
needing to be controlled. Managers may consider risk preferences and an organisation’s
goal or goals when making capital structure decisions. Therefore, my reason for
employing agency model in family firms covers two things. First, although there is a
separation between ownership and management in family firms, such firms are assumed
to be better at monitoring managers than other types of large shareholders, suggesting that
lack of alignment between managers and principals might be less prevalent in family
firms. However, this conclusion depends on the relationship between managers-principal,
manager’s behaviour and corporate governance in family firms. Second, the assumption
of conflict being mitigated between principals and managers lead family firms to act
towards capital structure decision due to the risk of bankruptcy and financial distress as a
result of having under-diversified investment and may face a high exposure of a single
asset, which is the family firm itself. However, this approach alone does not cover how
the contestability and distribution of power among the several shareholders of a firm are
52
relevant to this analysis. Hence, the next section will discuss the control approach and its
significance to this study. The control approach will connect to the issue of risk reduction
motivation that will explain, in the next section, the role of capital structure in family
firms.

3.2.1.2. The Control Approach

This approach focuses on the corporate contestability and the distribution of power among
the several shareholders of a firm. The control approach links corporate control and
capital structure, reflecting the fact that common equity carries voting rights, while debt
does not. Bolton and von Thadden (1998) state that from a large shareholder’s point of
view, new equity financing is not an optimal way to trade-off because their level of
control may be diluted. This statement in the context of firms with owner-managers
suggests that debt is an instrument to protect a founder-manager’s control as long as the
firm faces no financial distress and is performing adequately. However, in a case when
there are dispersed shareholders, with separation between shareholders and managers,
capital structure is relevant to the distribution of voting rights. Thus, control approach
will interconnect capital structure and ownership concentration.

From the perspective of corporate governance D’Mello and Miranda (2010) argue that
ownership structure and leverage can be seen as the internal control mechanisms to
alleviate agency conflicts that exist between different types of stakeholders inside firms.
Debt can serve as a disciplining mechanism between managers and dispersed
shareholders by imposing fixed obligations on a firm’s cash flow by the obligation to
meet interest payments. This view supports the claim made by Friend and Lang (1988)
that the presence of a group of investors might limit the discretion of management in
seeking lower debt ratios. In this context, the mechanism of monitoring is used by a
principal to reduce the potential for wealth diversion. However, in closely-held firms such
as family firms, debt can facilitate minority shareholders’ expropriation (Faccio et al.,
2001). However, at the same time debt may serve to mitigate agency problems between
controlling and non-family shareholders.

From the perspective of principals, leverage can be an expensive way to maintain

autonomy and to determine strategic decisions of their company, since higher
indebtedness increases the risks of bankruptcy and financial distress (Mishra and
53
McConoughy, 1990). As a consequence, if the dominant shareholder has already acquired
enough voting power it should not be expected that leverage would be used to achieve
control in strategic decision. This conclusion supports the study of Moh’d et al. (1998),
cited in the previous section, about the agency approach where the dominant principal is
associated with a lower debt ratio. Although control motivation exists, shareholders
remain to consider reducing agency problems, as well. In this situation I note the
interconnection between two approaches on leverage. However, the control may overlap
at certain concentration levels of ownership and may result in increasing leverage. In this
situation, increasing debt may be used for the maintenance of coalitions among dispersed
shareholders to enforce their interests. Thus, contestability affects the dominant
shareholder’s power over leverage. If transactions take place in the firm between the
principal and managers, suggesting the firm allows managers to make capital structure
decisions, control over critical financing sources is a significant managerial power. Even
without having ownerships fraction in the firm, managers have discretion to make a debt-
equity choice as long as the decision will ensure sufficient efficiency to prevent control
challenges.

If a fraction of a company’s equity is owned by its managers, who therefore obtain private
benefits of control, Stulz (1988) assumes that such managers will not tender their shares.
This can indicate there is an entrenched management, suggesting as long as managers
remain in control, debt levels will remains low. In such instances, where internal control
mechanisms fail to address entrenchment related issues, shareholders may rely on
external control mechanisms to redirect management towards optimal behaviour.
Therefore, any changes in leverage can be viewed as a response to opportunistic
management in the short-run, whereas control considerations may be less significant in
the long-run capital structures. This situation makes capital structure decisions dynamic
over time. Empirical findings show divergence on control considerations influence
financial leverage. This model predicts that leverage is positively correlated with the
extent of managerial ownership and a firm’s value (Harris and Raviv, 1988; Stulz, 1988);
and more concentrated ownership (King and Santor, 2008; Setia-Atmaja et al., 2009;
Margaritis and Psikalis, 2010; Ellul, 2010). However, other studies reveal a negative
relationship with concentrated ownership (Short et al., 2002; Anderson and Reeb, 2003c;
Maury, 2006; Croci et al., 2011; Ampenberger et al., 2013; Schmid, 2013; Santos et al.,
2014). In addition, Huang and Song (2006) found that managerial ownership has a
negative relationship with leverage in China. Finally, Agrawal and Naser (2011) found
54
the existence of a dominant shareholder is not related to the level of leverage. The
inconsistency of these results seems to demonstrate that control motivation can come
under pressure and possible struggle because of the risks of bankruptcy and financial
distress. In addition, the agency approach and control approach seem like two sides that
trade off each other. The control approach becomes relevant to this study, given that
family firm owners view their companies as an asset to transfer to the next generation,
thereby establishing a multi generation presence. In addition, they are shareholders with
control motives that maintain a long-term presence in the firm’s ownership structure,
suggesting that control motivation might be more prevalent in family firms than non-
family firms (Setia-Atmaja et al., 2009; Ellul, 2010; Croci et al., 2011). This approach
will connect to control considerations explained in the next section, regarding the role of
capital structure in family firms.

3.2.1.3. The Asymmetric Information Approach

This approach underlies the assumption that managers are assumed to possess private
information about the firm’s investment opportunities. The choice of the debt – equity
structure signals information to outside investors about a firm’s status and stability.
Managers are assumed to have a better understanding of, and more information about, a
firm’s potential investments and growth opportunities than outside investors; thus capital
structure decisions are proposed to benefits shareholders. Therefore, in my view
asymmetric information causes an imbalance of power between managers, shareholders
and outside investors. A lack of equal information may lead to economic imbalance that
results in strategic decisions. For instance, if investors are less informed than a firm’s
insiders, then equity may be mispriced by the market. Outsider investors may not be able
to discriminate between good and bad projects. As a result of this ignorance, interpreting
the firm’s decision to issue new equity as a possible sign of bad news will result in new
equity being priced accordingly. Investors will demand a high rate of return to invest or
the firm will be forced to issue equity at a discount. Underinvestment can be avoided by
financing the new project using security that less experienced undervalued by market such
as internal funds or riskless debt and then equity, as suggested by Myers (1984) as a
pecking order for financing.

55
However, Narayan (1988) and Heinkel and Zechner (1990) show that overinvestment
problems occur as a result of information asymmetry in a new project; potentially
attaching a negative value to the project. Thus, the solution to reduce the overinvestment
problem is by debt, because debt makes an investment less attractive to investors. Since
a new project is associated with issuing debt, then debt issues are good news; investors
take higher debt levels as a signal of higher quality projects. Ross (1977) shows
profitability, a measure of the firm’s quality, and debt-equity ratios have a positive
relationship. In contrast, lower quality firms have a greater probability of high bankruptcy
costs than do better quality firms. Managers of low quality firms will not decide to use
more debt to imitate those higher quality firms. Thus, in this approach profitability, debt
level and bankruptcy probability are all positively related. Several studies found that
leverage is positively associated: i) with profitability if used as a signal to the market
(Ross, 1977; Leland and Pyle, 1977), ii) the firm’s value (Ross, 1977), iii) managerial
ownership (Leland and Pyle, 1977), and iv) the firm’s size (Rajan and Zingales, 1995).
However, other researchers found that leverage has a negative relationship with
profitability if it refers to a pecking order for financing (Wald, 1999; Syam-Sunder and
Myers, 1999; Chen, 2004; Huang and Song, 2006) and free cash flows (Myers and Majluf,
1984). The reason why leverage has a negative relationship with profitability explicitly
has been investigated by Myers and Majluf (1984) and Myers (1984) who claim that
information costs cause firms to follow the lowest cost of capital, such as retained
earnings and debt. However, these claims have been contradicted by Baskin (1989), Allen
(1993) and Adedji (1998) who argue that information costs are not the only factors that
might drive the use of internal financing first, such as retained earnings. It was found that
control considerations may contribute to a reluctance to issue new equities that can
negatively impact the balance of power and control.

Thus, I indicate that there is an interconnection between asymmetric information that

causes an imbalance power between managers and investors (shareholders and creditors),
control considerations and agency issues relating to leverage. Debt has the ability to allow
shareholders to gather information useful for monitoring managers (agency argument)
and allows larger shareholders to discipline managers and dispersed shareholders (control
argument), since managers wants to continue the operations of a firm, even if liquidation
is in the interest of creditors. Managers may be reluctant to provide detailed information
that could result in the liquidation of their company (asymmetric information argument).
As creditors have legal rights, they can force managers to provide detailed information to
56
support their monitoring activities of the firm’s managers. By contrast, higher
indebtedness increases the probability of default, suggesting shareholders with enough
control rights will prefer lower levels of debt. Therefore, debt is not only about
contestability power, a mechanism of controlling and monitoring, but also about the
sustainability of a firm or firms in the long run, due to the risk of bankruptcy and financial
distress. In adopting these approaches in family firms, however, the owning families are
assumed to be better monitors of managers than other types of large shareholders,
suggesting that managers and principals are expected to be more closely aligned, as
compared to relationships in non-family businesses (Anderson and Reeb, 2003b). On the
other hand, family firms may have an incentive and ability to benefit at the expense of
dispersed shareholders through entrenchment management (Fama and Jensen, 1983;
Shleifer and Vishny, 1997). This possibility provides family firms with greater incentives
for both monitoring and entrenchment; thus the control approach may overshadow the
agency approach.

Table 3.1 shows each theoretical result; the type of approach from which the results
derived and the references that contained the results.

57
Table 3.1. Summary of the implications of capital structure theories and the empirical evidence of firms’ characteristics with
leverage.

Determinants Model Expected Theoretical References

Relation

Extent to which the firm is a takeover Control Positive Harris and Raviv (1988)
target
Increasing dispersion outside Control Positive De Angelo and De Angelo (1985)
ownership
Control protection/ Control motivation Control Positive DeAngelo and DeAngelo (1985);
Amihud, et al. (1990); Mishra and
McConaughy (1999); Ellul (2010);
Croci, et al. (2011); Santos, et al. (2014)
The probability of reorganisation Agency Negative Harris and Raviv (1990); Mishra and
following default/ Risk reduction McConaughy (1999); Schmid (2015)
motivation
Agency Negative Friend and Lang (1988);
Asymmetric Information Ross (1977)
Managerial equity ownership Agency Positive Harris and Raviv (1988); Stulz (1988)
Asymmetric Information
Free cash flow Agency Positive Jensen (1986); Stulz (1990)
Asymmetric Information Negative Myers and Majluf (1984)
Liquidation value Agency Positive Titman and Wessels (1988); Chen (2004)
(Tangibility/Asset structure)
(Non-debt tax shield) Agency Positive Titman and Wessels (1988)
Profitability Asymmetric Information Positive (signalling) Rajan and Zingales, 1995; Ampenberger
Negative (pecking order) et al.(2013); Chen (2004); Shyam-
Sunder and Myers (1999); Myers and
Majluf,(1984)
Agency Negative Chang (1987); Chen (2004)

58
Size Agency Positive Titman and Wessels (1988); Rajan and
Asymmetric Information Zingales, 1995; Myers and
Majluf,(1984); Fama and French (2002)
Growth Opportunities Agency Negative Jensen and Meckling (1976); stulz
(1990); Shyam-Sunder and Myers (1999)
Firms’ age Agency Positive Deesomsak et al. (2004); Anderson and
Managerial reputation Reeb (2003)
Cost of financial distress/Earning Agency Positive Fama and French (2002)
volatility Asymmetric Information
Liquidity Agency Positive Deesomsak et al. (2004)
Asymmetric Information

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3.2.2. Firms’ Characteristics

The empirical literature notes several characteristics that influence financing decisions in
a firm, including: a) asset tangibility (Titman and Wessels, 1988; Ozkan, 2001; Chen,
2004; Laery, 2009), b) profitability (Rajan and Zingales, 1995; Chen, 2004; Leary, 2009;
Ampenberger et al., 2013), c) firm size (Titman and Wessels, 1988; Rajan and Zingales,
1995; Myers and Majluf, 1984; Fama and French, 2002), d) growth opportunities
(Shyam-Sunder and Myers, 1999; Laery, 2009), e) non-debt tax shield (Titman and
Wessels, 1988), f) a firm’s age (Deesomsak et al., 2004; Anderson and Reeb, 2003), and
g) liquidity (Deesomsak et al., 2004). Although the theories are not developed with a
specific focus on family firms, it would seem logical to follow the factors claimed to have
some influence on corporate finance, since this study concerns about publically listed
family firms. Following the literature regarding firms’ characteristics is therefore
necessary in order to make judgements about connections between the observable studies
in family firms and relevant theories. While several of these judgements may seem
uncontroversial, there is room for significant disagreement in the case of family firms.

1. Asset Tangibility

Asset tangibility can be seen as a collateral available to creditors. Agency theory suggests
that firms with high leverage tend to under invest, thus transferring wealth away from
creditors to shareholders. This arrangement will be subject to less information
asymmetries between firms and creditors, indicating firms have a greater liquidation
value in cases of bankruptcy. Thus, in turn the agency cost of debt between shareholders
and creditors will be reduced (Titman and Wessel, 1988; Voutsinas and Werner, 2011).
The greater proportion of asset tangibility, the increase liquidation value, and the more
creditors willing to provide loans will all act to decrease the probability of mispricing in
the event of bankruptcy. The positive relationship between tangibility and leverage has
been reported by previous studies (Gaud et al., 2001; Ozkan, 2001; Chen, 2004; Laery,
2009 Ellul, 2010). Asset tangibility is easy to monitor, thus tending to mitigate agency
conflict between lenders and borrowers. The expenditure to monitor a firm with large
asset tangibility is likely to be reduced when compared to a firm with less asset tangibility.

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2. Profitability

Profitability is an indicator that firms are well managed and thus can be expected to be
more efficient than less profitable firms. Profitable firms face lower expected costs of
financial distress. In addition, the agency costs’ perspective predicts that the discipline
provided by debt is more valuable for profitable firms, due to free cash flow problems
(Jensen, 1986). In addition, creditors will anticipate that a profitable firm has a capability
to repay debt. In line with this view, creditors will provide greater levels of debt for a
profitable company (Heshmati, 2012). However, almost all empirical studies that have
examined firms and businesses found the relationship between profitability and leverage
to be negative (Chen, 2004; Aggarwal and Kyaw, 2010; Margaritis and Psillaki, 2010).
The reason for this finding is because more profitable firms have a strong enough position
to finance their business operations from internally generated funds, passively
accumulated profits (Kayhan and Titman, 2007), a company’s exhausted debt capacity
and the inability to raise more debt (Lemmon and Zender, 2010). In addition, profitable
firms prefer not to take on more debt in order to avoid the risk of bankruptcy in the long-
term, as well as being reluctant to issue new equity in order to maintain control. Thus, for
these reasons, I expect an inverse relationship between profitability and leverage in the
long-term.

3. Firm Size

Large firms have been shown to have lower levels of bankruptcy risk and relatively lower
bankruptcy costs; thus lower agency costs of debt and monitoring costs. Therefore, large
firms have benefits to access to funding sources, thus have more availability amount of
debt to a firm (Hooks, 2003). The firm size may indicate the information provided by
firms toward disclosure issues. Huang and Song (2006) support the idea that size can be
used as a proxy for information asymmetries. The larger the firm, the more information
can be accessed by creditors and so the probability that the firm will hide information
regarding the possibility of default will be less likely. A high degree of information
openness enables large firms to obtain greater leverage than smaller firms (Rajan and
Zingales, 1995; Fama and French, 2002; Frank and Goyal, 2003). To a great extent, larger
firms face fewer information problems; a situation which might increase the bargaining
power to creditors (Degryse et al., 2012). Another possibility is that large firms may have
a more diluted ownership, and thus have less control over individual managers (Chen,
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2004). Such a relationship suggests that managers may issue debt to reduce the risk of
personal loss resulting from bankruptcy (Friend and Lang, 1988). However, if a
company’s size is used as a proxy for the inverse probability of default, it should be a
negative relationship with leverage. Larger firms have a lower probability level of default,
suggesting that increasing leverage may actually increase their probability default level.

4. Non-debt tax shield

Non-debt tax shields (NDTS) may be regarded as substitutes for tax benefits of debt
financing. As a consequence, debt levels should be inversely related to the level of NDTS
(Santos et al., 2014), measured as depreciation to total assets. However, Ozkan (2001)
argues that NDTS may be a proxy for things other than the non-debt tax shield. Higher
levels of depreciation ratios may indicate that firms have fewer growth options or
investment opportunities and thus have relatively more tangible assets (Barclay and
Smith, 1995). Firms with more tangible assets indicate greater liquidation values and
NDTS. Those firms may have more debt, although they are more likely to default; at the
same time they will have higher market values than firms with lower liquidation values
(Harris and Raviv, 1990). In Indonesia, tax facilities have been regulated as a stimulus
for investment, based on Government Regulation No. 94, 2010, renewed in 2015 with
Government Regulation No. 18. According to these regulations, a corporate taxpayer may
be entitled to income tax benefits, such as an additional reduction in net income, up to 30
percent of the amount invested in tangible assets, charged at 5 percent per annum over
six years. This option can also involve accelerated depreciation and amortization.
However, the tax facilities in Indonesia must be met several criteria, such as firms must
have high investment value, high labor absorption, and high local content. In addition,
the industry sectors that are eligible include food, textiles, chemical and chemical
products, forestry and logging, coal and lignite mining, oil, natural gas and geothermal
mining. Thus, it may imply a positive relation between the non-debt tax shield and the
long-term leverage in the case of family firms that eligible to benefit this tax facilities.
Thus, these arrangements could imply a positive relationship between the non-debt tax
shield and the long-term leverage in the case of Indonesia firms.

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5. Firm’s age

Firm’s age should play a role in determining its capital structure because older firms may
have longer track records and therefore a higher reputational value than newer companies.
A firm’s reputation can be a good signal that the firm will take action consistent with
investors’ interests, thus getting more access to the capital market at relatively low cost.
Chua et al. (2011) argue that a firm’s age can be interpreted as a measurement of default
risk. Established firms have a reputation regarding creditworthiness with creditors and
should have a higher borrowing capacity because of reducing asymmetric information
and lower levels of financial distress. Empirical studies find that capital sources depend
on whether a business is developing or maturing (Dollinger, 1995), different financing
arrangements having been linked with business life cycles (Berger and Udell, 1998). The
interaction between lenders and borrowers over time may enable creditors to alleviate the
information asymmetry that can cause financial distress in a firm. However, Filatotchev
et al. (2006) and Johnson et al. (2016) suggest that as a firm ages after going public,
corporate restrictions and board members influence capital structure choices. As the firm
ages, the restrictions and boards are negatively correlated with leverage. This relationship
may be related to the risk reduction strategy that can impose costs on diversified
shareholders.

6. Liquidity

Illiquid firms face limits in attracting debt because financial distress will be indicated as
relatively high. Even though creditors could act as liquidity providers to their important
customers in distress (Oliveira et al., 2017), it is only a temporary solution because
providing additional debt to lenders can increase the creditors’ current liabilities. In
addition managers can manipulate liquid assets in favour of shareholders against the
interest of creditors, thus increasing the agency cost of debt. Illiquid firms induce financial
constraints, and thus increase the monitoring costs for creditors. This scenario suggests a
negative relationship between liquidity and leverage.

7. Firm’s growth

Firm’s growth can be seen as a good prospect from the viewpoint of its creditors. The
growing company has, at least potentially, a greater range and number of investment
63
opportunities. Therefore, such a situation is an opportunity for creditors to offer funds for
a firm’s investment, because firms with higher growth opportunities are more likely to
exhaust internal funds and require more debt than the firms that are not growing (Degryse
et al., 2012; Shyam-Sunder and Myers, 1999). Moreover, growth opportunities are likely
to have an inverse relationship with the probability of default and lender risk. Thus, firms
with higher growth opportunities may be less likely to default than the firms growing
more slowly, or not at all. This situation makes creditors more assured that they take on
less risk of the firm going bankrupt.

These results are summarised in Table 3.2 that show empirical evidence from G-7
countries (Rajan and Zingales, 1995), Thailand (Wiwanttankantang, 1999), 10
developing countries (Booth et al., 2001), United Kingdom (Ozkan, 2001), Spain (De
Miquel and Pindado (2001), USA (Korajezyk and Levy, 2003; Frank and Goyal, 2009),
China (Chen, 2004), Asia Pacific Region (Deesomsak et al., 2004), China (Huang and
Song, 2006), market based systems (UK and US) and banking based systems (France,
Germany and Japan) (Antoniou et al., 2008), Indonesia and Thailand (Bunkanwanicha et
al., 2008), 42 countries including Indonesia (De Jong et al., 2008), 40 countries involving
both developed and emerging markets, include Indonesia (Kayo and Kimura, 2011),
Indonesia (Moosa and Lie, 2012), and European countries (Jooever, 2013).

The next section will explain the role capital structure plays in family firm’s strategies,
starting from the characteristics of family firms that are most associated with the family
controlled shareholder, whose control motivation is prominent. However, risk avoidance
may need to be considered, where preserving the SEW and sustainability are both
important goals in a family firm. Elaborating the relationship between the components of
the organisation’s decision-making process will help in understanding the role of capital
structure decisions in a firm’s strategy.

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Table 3.2. Determinants of Leverage.

Characteristics RJ WW BO O DMP W C D HS A B DJ FG KK ML J

Asset Tangibility + + + + + + + + + + + -
Profitability - - + + - +/- - +/- - - - - - - -
Firm’s Size + + + - - - + + + + + + -
NDTS - - - - - - +/-
Firm’s Age
Liquidity + - - - -
Growth Opportunities - - - - - + - - - + - - -
The sign of ‘+’ and ‘–‘indicate the direction of significant relationship with leverage. ‘+’ means that characteristic increases leverage, and
vice versa for the ‘-‘sign. The studies are Rajan and Zingales (1995) (denoted RJ), Wiwanttankantang (1999) (WW), Booth et al. (2001)
(BO), Ozkan, (2001) (O), De Miquel and Pindado (2001) (DMP), Wald (1999) (W), Chen (2004) (C), Deesomsak et al. (2004) (D), Huang
and Song (2006) (HS), Antoniou et al. (2008) (A), Bunkanwanicha et al. (2008) (B), De Jong et al. (2008) (DJ), Frank and Goyal (2009)
(FG), Kayo and Kimura (2011) (KK), Moosa and Lie (2012) (ML), and Jooever (2013) (J). Comparisons suffer from the fact that these
studies used different methodologies, different periods of time, different measures of a firm’s characteristics, and different leverage measures.

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3.3. The Role of Capital Structure in a Family Firm’s Strategy

The interconnections of family business and capital structures can be explained by

viewing the situation as motivational based for influencing capital structure decisions.
Most pronounced in family firms are the issues of: i) control considerations and ii) risk
avoidance.

3.3.1. Debt as a Mechanism to Avoid Control Dilution

Control consideration may be related to a typical combination of concentrated ownership

and control that is common in family firms. These combinations allow concentrated
shareholders, in this context members of family firms, to benefit from investment projects
for private rents. This approach may take away resources from profitable projects in order
to satisfy the owner family’s interests. This action can occur when managers have
excessive power enabling them to take decisions to satisfy their own interests. Several
studies suggest that control motives can shape a firm’s capital structure decisions (Israel,
1991; Harris and Raviv, 1988; Stulze, 1988). These views are supported by empirical
findings such as those from Croci et al. (2011), Elul (2010) and Mishra & McConaughy
(1999) who found that control considerations exert a far greater influence on debt over
equity financing. It is possible that family firms will not put their control at risk and dilute
their powers due to their desire to preserve the family’s goals.

The fear of loss of control is likely to have a direct influence on levels of risk taking and
the choice of projects in which to invest. Anderson et al. (2003) found that on average
families have invested more than 69 percent of their wealth in the firm. This figure
indicates that family firms will be concerned to use debt to reduce the risk from under-
diversified investments and to maintain control over high risk exposure to one single
asset. Moreover, when owners are managers, they may use debt, instead of new equity,
to concentrate their voting power, since they are apprehensive that any change in capital
structure may dilute their power. They may consider out-of-pocket costs weigh more
heavily compared to the opportunity costs of a new capital structure. Once shareholders
own and control a firm, they would value the business more than they did prior to that
ownership. Mishra and McConaughy (1999) support this notion: ‘family firms are more

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averse to control risk and therefore avoid debt because increasing debt levels may increase
the risk of losing control of their firm’.

Control consideration becomes important in family firms due to their long commitment
to the business (Lumpkin and Brigham, 2011), their interest in passing the business on to
the next generations (Arregle, 2007), and their wish to maintain the reputation of the
family business (Schmid, 2013). However, it can be argued that the intention to be passed
to the next generation not only involves the family’s reputation, but also ownership and
managerial skills as a legacy of the founding / owning family. The long commitment is
related to the time and effort that the founder has invested since the firm’s beginning.
This personal investment issue may well lead to an escalation of commitment to a failing
project (Staw, 1976), but failure is disregarded as a sunk cost (Arkes and Blumer, 1985).
Thus decisions relating to capital structure are not only about the financial performance
that may follow from the new structure, but also about the outcome that an owner-
manager anticipates as a consequence of his or her ownership. Owner-managers are very
likely to have the feeling of possession, implying that one must take care of and maintain
the family firm. However, it is possible that over time the shareholders’ feelings of
ownership will have increased (Strahilevitz and Loewenstein, 1998), thus leading to a
status quo bias in capital structure decisions. The disadvantages of leaving the previous
capital structure and restructuring with a new capital structure loom large; on the other
hand the advantages family firms expect to get are uncertain. Managers could be reluctant
to acquire new equity in the capital structure due to an increase in the possession of the
firm, preferring to become familiar with the level of debt and investing themselves into
family firms through identification of control. Naturally, this situation is in a person’s
mind, based on the owner-manager principle that a thing which the individual has
enjoyed, and used as their own for a long time, will take root and cannot be torn away
without shifting behaviour to maintain sustainability.

On the other hand, it is possible that the family agents have their own interests; therefore,
to limit the destructive altruism within family firms, managers will be asked to employ
mode debt as a control mechanism in order to avoid the free riding problem among family
members. However, Kaye and Hamilton (2004) found that descendants are less likely to
use more leverage because they are more concerned with wealth preservation than wealth
creation. At this point, it can be argued that the level of debt can be in a stagnation

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position; descendants seem to be willing to maintain their wealth with certain holding
shareholders as long as this portion is enough to confirm their voting rights.

Several studies provide evidence that listed family firms are motivated to use debt as a
control consideration (McConaughy and Phillips, 1999; McConoughy et al., 2001). The
researchers suggest that large family firms in the US use debt as a control mechanism.
Moreover, Ampenberger (2013) and Schmid (2013) found this motive in Germany, while
others focused on Western Europe (Maury, 2006), France (Latrous and Trabelsi, 2012),
Australia (Setia-Atmaja et al., 2009), and Canada (King and Santor, 2008). Other research
initiative took place in 12 European countries (Croci et al., 2011) and 36 countries in the
rest of the world (Ellul, 2010). Therefore, it is of interest to note that empirical evidence
on this issue of capital structure supports the notion that debt has a role as a control
mechanism in family firms, due the maintenance of power over such firms and the
importance attached to the long term viability of those firms.

3.3.2. Debt as a Risk Reduction Strategy

Family firms are assumed to have, and belong to, large and undiversified shareholders.
This structure of shareholders leads family firm to be a risk avoider. The shareholders
may face a high exposure to a single asset, which is the family firm itself. Thus, they
have an incentive to reduce risk at the firm level. The risk can be financial and/or non-
financial, such as family reputation damage and financial distress (Schmid, 2013). Family
firms will avoid the risk that potentially can damage their goals to preserve the socio-
emotional wealth of such businesses. To some extent, this attitude makes them prefer less
risky financial options that potentially decrease the risk of loss family business to
creditors; default on payment can result in fatal consequences for the firm. Moreover, the
firm can be seen as a family asset which the members expect to be bequeathed to the next
generation. Such an expectation means the members may be averse to any decisions that
can harm their stakes in the business.

Consistent with this view, Gugler (2001) proposes that differing capital structure-related
decisions are due to the different incentives and motivations which are directly related to
the risk. Family firms use debt as a means of reducing undiversified risk, especially in a
situation where high levels of credit monitoring exist; as in Indonesia where a banking-
based system has been adopted. In these banking-based countries such as Indonesia,
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Germany and Japan Schmid (2013) found that if the level of creditor monitoring in an
institutional environment is high, family firms tend to avoid debt as a source of external
funding. This conclusion suggests that managers will consider reducing the agency costs
of debt and potential constraints imposed by creditors. Thus, a risk reduction strategy may
be related to the family firm’s strong interest in long term survival. This situation causes
managers to minimise risk coming from the financial distress of restructuring, a situation
which can damage a family’s reputation. Mishra and McConaughy (1999) suggest that
higher levels of debt increase the likelihood of a firm’s bankruptcy, as well as upping the
levels of risk control. This conclusion shows that the choice to use debt is more sensitive
to conditions associated with risk control. However, risk reduction may have the side
effect of reducing potential growth rates by giving up profitable growth opportunities
(Schmid, 2013). In this situation, these excessive fears could reduce the attractiveness of
family firms for investors, because family firms may be more sensitive to losing the
family’s wealth than to increasing that wealth through nurturing the growth of their firm.

Despite the two roles of debt as a mechanism to avoid control dilution, and as a device of
risk reduction against default, a normative approach of rational choice of managers is
based on the utility concept. Managers are presumed to be rational regarding the
expectations of all investors, both shareholders and creditors. The expectations of
shareholders and creditors are related to the overall outcomes of financing decisions.
Under uncertain situations in the future, owner-managers make decisions by maximising
the expected utility of wealth. However, the rationality assumptions do not take into
consideration that essentially, managers have their own interests. Managers will be more
concerned with the outcome of overall capital utility as it is reflected in the weighted
average cost of capital. Thus, as long as managers can minimise the agency cost of debt,
the prevalence of risk aversion is perhaps the best-known generalisation regarding risky
choices (Kahneman and Trevsky, 1979).

Overall, capital structure decisions have an important role as one major channel through
which a control-motivated family can defend their firm and risk reduction-motivation in
order to preserve the family firm’s goals. However, I will argue that the long-term family
goals are concerned not only with maximising the wealth of the founding family and
minimising the agency cost of debt as economic goals, but also with preserving non-
economic goals; the latter being the family firm’s long-term survival and sustainability.
Achieving these goals will ensure the existence of managers’ and owners’ interests; both
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economical and non-economical. Table 3.3 shows a summary of the literature on the role
of capital structure in family firms.

Table 3.3. Literatures about the empirical evidence on the role of capital structure
in family firm.

Author (s) & year Roles/Findings Countries

Mishra and Risk reduction strategy of loss of family business. USA

McConoughy (1999) Debt is associated with controlling bankruptcy risk of family
firm, thus use lower debt level.

Maury (2006) Mechanism to avoid control dilution. Western Europe

Debt is used in family firms due to control motivation and
reducing conflicts between the family and minority
shareholders when shareholder protection is low.

Ampenberger et al. Mechanism to avoid control dilution. Germany

(2013) Debt level is mostly impacted by management involvement.

Schmid (2013) Mechanism to avoid control dilution. Germany

Debt is used in order to control the firms.

Santos et al. (2014) Risk reduction strategy of loss of family business. 12 Western
Debt for family firms is used due to risk of bankruptcy and Countries
financial distress as a result of having an under-diversified
portfolio.

Anderson and Reeb Risk reduction strategy of loss of family business S&P 500
(2003) Family firms in the Unites States employ less leverage to
minimise firm risk.

Margaritis and Psillakis Mechanism to avoid control dilution. French

(2010) Debt is used as a control mechanism of family firms.

King and Santor (2008) Mechanism to avoid control dilution Canada

Debt is a control-enhancing mechanism in family firms.

Setia-Atmaja et al. Mechanism to avoid control dilution. Debt is used as a control Australia
(2009) mechanism and as a substitute for independent directors.

Ellul (2010) Mechanism to avoid control dilution 36 countries

Debt for family firms is used strategically as a control-
enhancing mechanism.

Croci et al. (2011) Mechanism to avoid control dilution 12 European

The financing policies are influenced by control motives. countries.

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