Impact of Recession on Capital Structure

Introduction and Initial Reviews

Capital structure as a topic remains one of the most critical topics in corporate finance for academic researchers and practitioners alike. A number of theories on capital structure have been put forward in the recent past to justify the difference in debt ratio across firms. From 1958, when Modigliani and Miller put forward the modern capital structure theory, three major conflicting capital structure theories have been developed. These are the pecking order theory (Myers & Majluf 1984, p.1), agency cost theory (Jensen & Meckling 1976, p.2) and the static trade off theory Bradley et al. (1984, p.6). A number of literatures on the theory of capital structure and the determinants of company capital structure have been published over the years. Most of the data used in the literatures were sourced from the first world countries: Elsas and Florysiak (2008, p.1), Flannery and Rangan (2006, p.469) among others.

Background and Rationale

One of the primary research problems in corporate finance is how a recession influences the adjustment of a firms capital structure. It is, therefore, desirable to observe the behavior of a sample of firms distressed by recession and see how it influences their capital structure. The recessionary periods of 1997 and 2001 significantly affected the Turkish economy. Many companies that were highly leveraged went bankrupt. These bankruptcies consequently affected the financial sector players that were linked to the affected firms. The affected firms had to endure significant restructuring after the recession period.

The current study intends to make a detailed analysis of the impacts of a recession on a firms choice of capital structure. Data from Istanbul Stock Exchange (ISE) is used in carrying out an empirical analysis on Turkeys non-financial firms over the period 1992- 2003 when the Turkish economy suffered a major recession. The findings indicate that recession impacts on firms capital structure choice, however, the extent of the impact to a large extent depends on how severe and abrupt the recession is. A severe and prolonged recession with severe effects has worse negative effects on the capital structure of the organization as compared to a short recession.

Capital structure, ideally refers to a companys financial framework comprising of debt and equity which it uses to finance its operations. In the finance field, capital structure is one of the areas that have received considerable attention from researchers. In financial terms, Saad (2010 p. 105) defines capital structure as the way a firm finances its assets through combining debt and equity or the use of hybrid securities. In summary, capital structure is a combination of a companys short term and long term debts, preferred equity and common equity and is vital for the functioning of the firm.

A significant volume of the research has been done to investigate factors determining a firms capital structure (Konstantinos 2011, P. 320). These studies have mainly focused on macroeconomic and firm specific capital structure choice determinants. Even though short term and long-term debt financing preferences of companies have been widely assessed, there is some literature on how factors such as recession influence the sources of debt financing, for example, financial and trade credits (Devarajan et al. 2011, p.421).

Capital structure varies from firm to firm. A firms choice of debt depends on the availability and the cost of debt. In the absence of bonds, debt financing comprises of only two sources: financial and trade credits. According to Bugamelli et al (2010, p.156), trade credits are more expensive relative to financial credits. When central banks pursue money-tightening policies, firms prefer to use trade credits rather than bank credits. In the same way, if the financial market collapses, it is expected that trade credits will substitute financial credits (Love 2007, p.213)On the other hand, equity financing can rarely replace financial and trade credits. This is the case during a recession. In the pecking order theory, equity financing is regarded as the last resort. Firms have the option of raising capital through rights issues. The significance of the current study is that it examines in detail how economic recession impacts on the choices of capital structure of companies listed in the Istanbul Stock Exchange (ISE) over the period 1991-2003.

Conceptual Framework and Literature Review

Modigliani and Miller 1958 introduced the irrelevance principle in capital structure. Since then, a lot of research has been done with the objective of understanding firms’ capital structure. It is from this that a number of theories on capital structure have been proposed to explain the mix of debt and equity in company financing. In this section, we will review the main theories that have been written in the field of capital structure. First, we will review the principle set out by Modigliani and Miller, followed by the trade off theory, the pecking order theory and the agency costs theory.

Modigliani & Miller Theorem

The first theoretical perspective that reviewed capital structure was the M & M theorem, which presents the earliest attempt in trying to explain the capital structure of firms. The theorem, formulates three propositions, set in an efficient market with no taxes, agency costs, bankruptcy costs asymmetry of information. The three propositions include: cost of capital and leverage which deal with valuation of securities, the last one is valuates the significance for investment theory.

M & M fist preposition states that a firm’s total value will always be constant regardless of the mix of debt and equity. It equally argues that the total cost of capital cannot change regardless of the capital structure and will always equal the rate of discount for capital investments. The second proposition states that the expected returns from stocks are equal to the sum of capitalization rate and premium for the financial risks times the debt ratio (Heshmati 2001, p.47). Because creditors are in position to claim assets in case of default, the cost of equity is always higher than the cost of debt. The reduction in the cost of debt is compensated by an increase in the cost of equity when the ratio of debt to equity increases and as a result, the final cost of capital remains the same (Myers 2001, p.87). According to the M&M theory, therefore, if it will be useless for firms to spend their time in optimizing the capital structure because doing so will not make any changes. In general, given the fact that M & M theory considers a perfect market, it can be a good ground for ascertaining why a firm’s financing matters (Frank & Goyal 2007, p.9).

Trade-off Theory

The theory was developed to correct some of the assumptions made in the M & M theorem, mainly, bankruptcy costs and taxation. Overall, the trade off theory elaborates capital structure by contrasting the benefits and costs of using debt in financing. According to Frank and Goyal (2007, p.8), the term trade off theory can also refer to a number of other theories regarding the advantages and disadvantages of leverage.

Following the publication of the M&M theorem in 1958, debate arose as to the unrealistic nature, of the methodology adopted. However, by 1963, Modigliani and Miller published a new article that tried to address some of the flaws in the 1958 article, by adding an extra assumption that firms had corporate tax. Firms that pay corporate tax enjoy certain benefits from using tax because before their earnings are taxed, interest on the money borrowed is deducted thereby providing a tax shield. This in turn implies that firms that pay high corporation tax and make more profits stand to benefit more. They further argued that the cost of debt financing would be lower as leverage level increases, which implies that the optimum capital structure will comprise of 100 percent debt (Heshmati 2001, p.76). The static trade off theory, is comprehensive in explaining that a firms capital mix should be stationary at the optimum level, taking into account the taxation expenses and bankruptcy costs.

This seems much unlikely because, in the real world, firms do not employ 100 percent debt in their capital structure. It is for this reason that an alternative to constant debt financing that incorporates increased leverage ratio had to be introduced. Under the new alternative, the central subject was the bankruptcy costs. It is obvious that when a firm increases its leverage ratio, it increases its chances of defaulting on its debt payments with bankruptcy costs forming part of the financial distress. Among the bankruptcy costs include liquidation costs incurred when a firm liquidates its net assets in order to pay its creditors for the outstanding debts (Moore 2011, p.104). According to Bandt et al (2008, p.258), as firms increase the amount of debt, then their probability of falling into financial distress increases thus increasing the cost of debt financing.

The concept of an optimum point in the choice of debt and equity when taking into account bankruptcy costs and taxes is referred to as the static trade-off theory. Myers (2001, p.88) asserts that when the cost of a firms financial distress is still lower than the benefits associated with a tax shield, then firms will have an incentive to increase their debt ratio. Beyond this point, a firms market value will begin diminishing because the financial distress cost overweighs the tax shield as indicated in Appendix Figure one.

However, the static trade-off theory has one limitation; it is a one period theory that does not take into account companies lasting more than one period. It bases on the notion that companies plan their capital structure only one period ahead. To solve this inherent weakness, the dynamic trade-off theory was formulated. The dynamic theory takes into consideration a firms future expectations and that variations in the capital structure are often accompanied by transaction costs. The dynamic trade-off theory permits firms to have a flexible capital structure that is tuned over time to match optimum future capital structure (Frank & Goyal 2007, p. 19).

Agency Costs Theory

According to Jensen and Meckling (1976, p.52), the trade-off theory needs to add another extra assumption to the 1958 M & M theorem. The authors noted that in reality leverage ratios were low, necessitating the need for an additional factor against the benefits of debt. In addition to the bankruptcy costs, Jensen and Meckling (1976, p.54) added the agency cost, thereby, creating an additional challenge to the merits of using tax shields and debt (Myers, 2001, p.89). Agency costs by definition refer to information imbalance that exists between shareholders, managers and lenders. It is a problem originating from the difference in knowledge held by various stakeholders in a company. This is a potential agent-principal problem where the agent acts against the interest of the principal. In the context of the firm, the principal refers to the lenders and shareholders while the agent refers to the management (Heshmati 2001, p.81).

Jensen and Meckling (1976, p.52) argue that agency costs are divided into two: costs associated with the principle agent relationship that involve the shareholders and the management and on the other hand costs involving lenders and shareholders. Firm managers have a tendency of investing the available cash flow in risky and value decreasing projects and at their own discretion; this denies the shareholders the dividends that they would have otherwise earned (Julie 2006, p.15). In addition, C.J.C (2009, p.1) argues that managers prefer to continue with a firms ongoing operations even though it would be in the interest of the shareholders to liquidate these investments.

Shareholders can reduce this conflict if they insist that the firm should issue more debt such that fewer funds are available to management because they have to pay interest on the money borrowed. This approach however, is likely to lead a firm into bankruptcy. According to Kira (2009, p.40), the optimum capital structure can be achieved by foregoing the benefit of debt to prevent management from investing in those projects that add no value to the shareholders. Furthermore, firms that have high leverage might suffer other principal-agent problem between the lenders and the management. This is the problem of under investment. However, there may be projects that have positive net present value; the management may reject them in favor of the shareholders’ interests. This is because any gains from projects will be passed over to lenders in the form of debt repayment (Bugamell et al. 2010, p.156). Lenders, therefore, have to continuously monitor a firm’s investment activities to minimize the possibility of under investment. Monitoring can be achieved through debt agreements and contractual covenants. It is worth noting, however, that monitoring costs are passed over to the borrower, therefore, increasing the cost of borrowed capital to the firm. In summary, the trade-off theory advocates for an optimum capital structure that balances bankruptcy and agency costs, with benefits of tax shield.

Pecking-Order Theory

Myers and Majluf in 1984 also introduced the pecking order theory as a choice of capital mix by firms. Under this theory, firms prefer internally generated funds as the first source of capital. Where internal finance is unavailable, firms will borrow externally by choosing the cheapest and most safe solution. Under the theory, debt has priority over the issuing of equity. Unlike the trade off theory, the pecking order theory excludes a target debt to equity ratio (Myers 2001, p.44). The pecking order theory arises from the fact that some players have more information on a film’s true condition, for instance, available investment opportunities, growth prospects and the return streams. A firm’s management or insiders, usually posses better knowledge than outsiders (investors and lenders).

In summary, the pecking order theory assumes that there is the information asymmetry between the external and internal stakeholders and the costs associated with this asymmetry determine the capital mix choice of a firm. Because of this, there is no optimum choice of debt-equity mix for firms but rather internal sources of finance are prioritized as the first source of financing. When it comes to debt, the safest source of debt is ranked first for example short term debt is preferred to long term debt finally in the choice of equity, preferred stocks are preferred to common stocks (Myers 2001, p.87).


The data used in the study is obtained from Istanbul Stock Exchange (ISE) that comprises of non-financial firms listed in the ISE. Panel data for the period 1991-2003 is employed in generalized least square estimation models. Moore (2011, p. 105) argues that when we use a large population sample, then the characteristics of the population take centre stage relative to the particular effects of individual observations. Under such cases, the random effects model such as the generalized least squares becomes more appropriate. It is for this reason that the study adopts random effects model. To ensure accurate results, outliers in the sample are eliminated by assessing the distribution of key variables.

As noted in the literature review, capital structure determinants have received considerable attention of the past few decades. The most popular variables in the determination of capital structure included: Business risk (VC sales), this is the variation coefficient of sales. According to Kira (2009, p.40), the variable measures how a firm’s leverage is affected by business risks. A companys operating income is majorly a component of sales as a result, variations in sales and cash flow indicate future business prospects. A company whose sales are constantly fluctuating has a high risk of defaulting on its interest repayments. As a result, sales’ volatility is projected to be inversely related to leverage.

The second variable is the natural logarithm of a firms total assets (ln TA). According to Titman and wessels (1988, p. 18), compared to big firms, small firms are more exposed to credit defaults. Big firms have the advantage of securing debt easily. The variable ln TA represents default risk and bankruptcy. Konstantinos et al. (2011, p.322) argues that majority of the big Turkish firms used more debt in financing. For this reason, we expect a positive correlation between the size of the firm and the level of leverage.

The third variable is Tangibility expressed as a ratio of fixed assets to total assets (FA/TA). Tangible assets such as plant and machinery can easily be used as collateral in securing loans from lenders. A lender who extends a loan to a firm, which is highly collateralized, eliminates the risks of agency cost of debt. Leverage is, therefore, expected to be more in investment firms. FA/TA is projected to have a positive relationship with leverage level. Two authors Bugamelli et al (2010, p.156) argue that a positive and significant relationship exists between a firms leverage and its tangibility (FA/TA). Conversely, Bandt (2008, p.260) argue that, in mainland China, the correlation between tangibility and leverage level is negative.

Fourth is the Market Value to Book Value variable (MV/BV). This is a firms total market value divided by its book value of the equity. The ratio weighs the growth prospects of a firm. According to Gonenc (2003, p.43), a significant relationship exists between a firm’s capital mix and its market to book ratio for Turkish firms listed in the Istanbul Stock Exchange.

Fifth is the net income to total assets ratio (NI/TA). Kim, Heshmati and Aoun (2006, p.275) argue that for Korean listed companies, their profitability level is inversely correlated to the debt ratio. In addition, Booth et al (2001, p.87) asserts that in emerging markets, as a firm becomes more and more profitable, its debt ratio becomes smaller and smaller. They further argue that firm profitability in developing markets has strong links to information imbalance and principal agent problem. For companies in Turkey, Gonenc (2003, p.40) found an inverse relationship between debt to equity ratios and profitability.

A firm’s growth, the variable is also used to indicate the growth prospects of a firm. It is calculated by deducting the total assets of the previous period from the total assets of the current period divided by total assets of the previous period. (TAt-TAt-1)/ TAt-1. A company with higher growth prospects is naturally expected to have higher financial requirements and therefore tends to focus more on debt as a source of financing the extra capital requirements (Titman & Wesels 1988, p.310). Debt financing provides an avenue for raising funds for firms that cannot generate the same internally. Furthermore, lenders of debt may lend to the borrowers based on an individual firm’s future prospects. We expect a positive correlation between leverage and growth as measured by the growth of total assets.

Non-debt Tax Shield (DEP/TA), this is calculated by dividing a firm’s depreciation expense by its total assets. This variable is used as a tax shield. Firms prefer debt financing because of the tax shield advantages associated with it even though depreciation equally provides the same advantage. According to Julie (2006, p.17), evidence suggests that the tax advantage arising from depreciation impacts negatively on a firm’s leverage.

The next variable in the recession is a dummy variable (94D and 01 D). A dummy variable takes on the value of 1 if a recession occurs in that particular year. Because recession erodes purchasing power and leads to serious liquidity problems for companies, we may project a negative relationship between recession and leverage ratios of firms. During the sample period, two recessions occurred: the one of 1994 and the one of 2001.

Model Building

In model 1, all the variables listed above will be included as independent variables. CS denotes capital mix, which is the dependent variable. Because the company’s mix of debt and equity is measured using six differentiated ratios that include total debt to total asset, long term debt to assets, debtors to assets, total debt to assets, short term debt to assets and finally financial debts to assets, the first model will give rise to six different equations.

CSt0 + σ1ln TAt + σ2 (TAt -TAt-1)/ TAt-1+ σ3NIt/TAt + σ4FAt/TAt+ σ5VCSALESt+ σ6DEPt/TAt+ σ7MVt/BVt+et

Where CSt-capital structure, ln TAt-natural logarithm of total assets, TAt-1, total assets in the previous period, NIt/TAt-the ratio of net income to total assets, FAt/TAt-ratio of fixed assets to total assets, VCSALESt– variation coefficient of sales, DEPt/TAt– the non debt tax shield and MVt/BVt– is the ratio of market value to book value. σ0is the intercept, σ1– σ7– represents the respective regression coefficients of the variables, while et– is the error term.

The second model comprises of recession variables added to the variables in model (1). The model tests the impact of a recession on the capital structure variables. Similar to model (1), model (2) gives six different equations.

CSt0 + σ1ln TAt + σ2 (TAt -TAt-1)/ TAt-1+ σ3NIt/TAt + σ4 FAt /TAt+ σ5VCSALESt+ σ6DEPt/TAt+ σ7MVt/BVt+ σ894D + σ901D+et

Where 94D and 01D are the 1994 and 2001 recession dummy variables respectively.

Model three represents a regression model that forecasts the effect of a firms characteristic and economic recession on company rights issue. It is a dummy variable that assumes the value of 1 if the firm issued its rights in year t, otherwise it is 0.

Empirical Results

Table 1 indicates the results of leverage ratios across industries. The results show the findings for short-term debts, long-term debts, trade credits and financial credits. Looking at all the leverage ratios, there is a significant deviation between the industries. The Turkish firms use a high debt ratio of 61 percent. Short-term debt remains the dominant source of financing. Given the historical inflation in turkey that lasted for many years, short term debt was the main credit tool for getting emergency credits because of its availability and low cost. This confirms Booths et al (2001, p.222) findings that the use of short term debt in Turkey surpasses that of long term debt. The evidence further suggests that there is a preference for financial debt as opposed to the use of trade credits. From the year 2001, it is evident that majority of the Turkish firms (83 percent), relied on debt financing. This explains why the Turkish economy was more delicate during the recession years.

Table 2 indicates the impact of exogenous variables on the four common leverage ratios in section A. The results in section B further indicate the impact of the two economic recessions (1999 and 2001) on the leverage ratios. The findings in section A, suggest that growth and opportunities for growth have a significant and positive effect on leverage ratios. It further indicates that profitability and tax shield have an inverse but significant effect on the leverage ratios.

The findings of the present study are in line with those of Titman and Wessels (1998). A firms equity structure is affected by its level of profitability. Low debt levels arising from a firms ability to generate funding internally, leads to higher returns. The inverse relationship that exists between leverage ratios and profitability supports the pecking order theory.

There is a significant but negative relationship between the non-debt tax shields as projected by the trade off model. Companies with greater non-debt tax shield have less debt ratios. Tangibility has been found to have a positive and significant impact on both total debt and short term debt ratios, in addition, it has a positive and significant effect on a firms long-term debt ratio. A firms long-term debt capacity increases with the proportion of tangible assets.

The findings indicate that on average, the short-term debt ratio is higher among the Turkish firms. Furthermore, the impact of business risk on leverage is both significant and positive contrary to the expectations made earlier. According to Durukans (1996, p.47), this is the case when business risk is used to measure business risk.

In section B, two additional dummy variables are introduced into the model to assess the impact of recession on leverage. The 1994 recession has a negative impact on the debt ratio. This explains why during the 1994 Turkish recession, debtors reduced their lending. On the other hand, the correlation between the 2000-2001 recessions is generally positive, although negative for long-term debt and only significant for debt equity ratio. The results indicate that firms prefer to use short-term debt in resolving their liquidity problems during a recession. Worth noting was that both debtors and firms did not involve themselves in long-term contracts during the 200-2001 recession. This finding is due to a decrease in the level of firm equity due to the high losses incurred during the recession.

The market to book ratio mean value, which measures available investment opportunities, indicates that the contraction in stock prices between the years 200-2001 was highly significant. Because of this, the market leverage ratio sharply increased. However, no changes were observed in the book leverage. This can be attributed to the fact that the measure of market leverage is significantly affected by the stock price of a firm, on the other hand, a firm’s measure of book value is affected by its accounting value of equity which includes changes in dividend that are highly and negatively significant, and variations in retained earnings (positively significant). Both measures equally reflect the effect of net debt issue (not significant but positive) and new equity issue (not significant but positive). When companies are faced with chronic cuts in aggregate demand during a recession, it results in the lower cash flows leading to a boost in the volume of retained earnings because firms reduce on debt obligations and dividend payments.

The findings in this study are consistent with those of Konstantinos et al. (2011, p. 334) who report stability in corporate capital structures over long periods. The evidence also supports the pecking order theory that predicts that the decision to pay dividend is always residual because the management distribute the remaining cash balance after fully exhausting other investment opportunities. The existence of a marginal yet significant change in the net debt may be a sign of the presence of bankruptcy costs and management’s desire to roll back their leverage. In summary, managers will always reduce on the dividend payments and, at the same time, reduce the net debt during the recessions to minimize the reduction in a book value of equity.

Table 3 indicates the results of trade creditors and financial debt regression. As the descriptive statistics in Table 1 indicate, Turkish firms prefer to use financial credits to trade credits. This argument is the same as that of the pecking order theory as put forward by Peterson and Rajan (1994, p.65) who argue that when firms are faced with financial distress, they first use the retained earnings or credits from banks before using trade credits. Why this is so is because trade credits, as a form of financing is more expensive relative to financial credits. Equally, the size of a company affects positively on creditors. Large companies are in a position to secure higher trade creditors. This is because they have a good reputation in the market and they are more dependable. In addition, they have a better bargaining power over their suppliers. The size of a firm coefficient is equally positive and significant for financial debt.

The result confirms the expectation that large companies can secure debt financing much easier compare to small companies. The findings related to tangibility, profitability and growth are in synchrony with the other leverage ratios for trade creditors and financial debt. The tax shield in addition to the market to book ratio impact significantly on a firms financial debt as projected. However, it does not affect trade creditors. Corporation tax does not affect trade creditors; however, it has an impact on financial debt. When the recession variables are introduced into the model, the findings indicate that the 2000-2001 recession has a negative but significant influence on trade creditors. This is a sign that during the recession, companies found it hard to extend their credit lines with their suppliers. Compared to the 2000-2001 recession, the 1994 recession had a direct significant influence neither on the trade creditors nor on financial debt.

In Table 4, in the appendix, is the logit regression outcome for the rights issues. The dependent variable is 1 engages in a rights issue in the year in question and 0 otherwise. Between the years 1991 and 2003, there were 1750 firm year observations in total.

In model 1, only market book value, tangibility and growth are incorporated as dependent variables. The findings indicate that the market to book value and a firms growth significantly influence the firms choice of rights issues. In model 2, an additional dependent variable, profitability, is added into the equation. Profitability is found to have a significant but negative influence on the choice of rights issues.

When all the findings are interpreted together, they indicate an inverse yet significant correlation between the size of a firm, its growth opportunities, its profitability and the choice of the rights issues. Companies with limited tangible assets, lower market to book ratio and less debt, are more likely to raise their capital through rights issues compared to firms that have more fixed assets, robust growth opportunities and are more profitable. Small upcoming firms with limited fixed assets and low profitability may not be able to access funding from the commercial banks and therefore the only possible alternative is to raise capital through their stockholders.

When the recession variables are added into the model, the signs of the recession are significant. Despite the fact that the relationship between that the 1994 recession and the rights issues were positively and significantly related, the 2000-2001 recession and the rights issues decisions though significant, is negative. Such differences can be explained by the variations in the nature of the two recessions. The 1994 recession was a more severe and abrupt economic crisis that affected the non financial firms which formed a significant part of the current studys sample. During the 1994 recession, companies resorted to financing their operations though the issuing of rights to their existing shareholders because the interest rates on loans had increased significantly. Conversely, the 2000 to 2001 recession marked the end of an ongoing economic slump. As a result, existing companies during the 2000-2001 recessions might have readjusted their capital mix to match with the falling economy.

Conclusion and Recommendations

The current study investigates the effect of economic recession on a firms choice of capital mix. In addition, it analyzes the firm specific factors that affect capital structure by grouping the capital structure decision into short-term debt, long-term debt, total debt, financial debt, trade creditors and equity related issues. Modigliani and Miller 1958 introduced the irrelevance principle in capital structure. Since then, a lot of research has been done with the objective of understanding firms capital structure. It is from this that a number of theories on capital structure have been proposed to explain the mix of debt and equity in company financing. The first theoretical perspective that reviewed capital structure was the M & M theorem, which presents the earliest attempt in trying to explain the capital structure of firms. The theorem, formulates three propositions, set in an efficient market with no taxes, agency costs, bankruptcy costs asymmetry of information. The three propositions include: cost of capital and leverage which deal with the valuation of securities, the last one is valuates the significance for investment theory.

Generally, the results of the recession indicate that the 1994 economic recession is more significant on capital structure decision of firms compared to the 2001-2001 economic recession. The wide variation in the findings may be explained by the fact that the two recessions had significant differences both in terms of their impacts and in terms of occurrence. The 1994 economic recession was extreme and swift and it had a greater impact on the manufacturing companies. During the 1994 recession, companies reduced on their debt levels. The 2000-2001 recessions marked the end of an ongoing economic decline so that its effect on the capital structure of firms was as strong as the 1994 recession.

The non-financial firms listed in the Istanbul Stock Exchange (ISE) seem to have large sums in debt, especially short-term debts. Turkey being a bank oriented market makes debt financing a more appealing option. From the analysis of firm specific factors that influence capital structure, it is clear that the findings are in line with those of previous literatures on developing markets. Future growth prospects, profitability, size, growth, tax shield, operating risks and the level of fixed assets appear to influence the level of both short term and long-term debt.

The findings from the assessment of financial debt and trade creditors point to the fact that market-book ratio and tax shield significantly influences only the level of financial debt as projected but not on trade creditors. Taxation, on the other hand, has no influence trade creditors but positively influences financial debt.

The empirical findings support the pecking order and trade off theories. Firms prefer to finance their operations through debt when the tax benefit associated with financial debt is high. This supports the trade-off theory. In addition, Turkeys corporate bond market is still developing and as such when the economy suffers from a recession, firms are pushed to rely more on short term debt. This supports the pecking order theory.

Generally, companies are usually able to maintain the book leverage levels that existed prior to recession. They achieve this by counterbalancing their decreased book value of equity arising from the losses induced by the recession, with reduced debt and dividend levels. Despite the existence of a recession, available evidence suggests that management is actively involved in the management of the capital structures. It is expected that such managerial efforts in conjunction with increased stock prices in the end, will probably restore the market leverage level that existed before the recession.

The findings from the logit regression analysis indicated that companies with limited fixed assets, small profits, less debt and a small market to book ratio are more likely to raise their capital by issuing rights to their existing stockholders. Therefore, small upcoming companies with few fixed assets and low bottom lines may not be in a position to finance their investments through bank loans. They, therefore, choose to raise the funds though their stockholders. The addition of the recession variables into the model, points to the fact that both recessions (the 1994 and the 2000-2001 recessions) positively influenced the decision by management to issue rights. When these findings are analyzed together with the leverage findings, it can be concluded that companies tend to reduce their debt levels during recession periods and resort to financing their operations through the issuance of rights when sudden and drastic economic recession occurs.

List of References

Bandt, O, Bruneau, C & El Amri, W 2008, ‘Finance’, de Journal of Financial Stability, 4 (3), pp.258-74.

Bugamelli, M, Cristadoro, R, Zevi, G & Giornale, 2010, ‘International crisis and the Italian productive system: an analysis of firm-level data’, Economisti e Annali di Economia, 69 (2), pp.155-88.

C.J. 2009, ‘Bankruptcy Round ’09: Creditors take the gloves off’, Bank Loan Report, 24 (5), pp.1-4.

Devarajan, S & Louis, A 2011, ‘Africa and the global economic crisis: Impacts, policy responses and political economy’, African Development Review, 23 (4), pp.421-438.

Elsas, R & Florysiak, D 2008, ‘Empirical Capital Structure Research: New Ideas, Recent Evidence, and Methodological Issues’, Discussion paper, 1 (2), pp.1-47.

Flannery, M & Rangan, K 2006, ‘Partial adjustment toward target capital structures’, Journal of Financial Economics, 79 (2), pp.469-506.

Frank, M & Goyal, V 2007, Trade-off and pecking order theories of debt, Web.

Julie, M 2006, ‘Counterparts?’ Monthly Labor Review, 129 (7), pp.15-26.

Kim, H, Heshmati, A & Aoun, D 2006, ‘Dynamics of capital structure: the case of Korean listed manufacturing companies’, Asian Economic Journal, 20 (3), pp. 275-302.

Kira, N 2009, ‘Cap or good hope’, Money Marketing, 1 (2), pp.40-40.

Konstantinos, V & Werner, A 2011, ‘Credit supply and corporate capital structure: Evidence from Japan’, International Review of Financial Analysis, 20 (5), pp.320-334.

Modigliani, F & Miller, M 1958, ‘The cost of capital, corporation finance and the theory of investment’, The American Economic Review, 478 (3), pp. 261-297.

Modigliani, F & Miller, M 1963, ‘Corporate income taxes and the cost of capital: A correction’, The American Economic Review, 53 (3), pp.433-443.

Moore, J 2011, ‘Bank Performance Prediction during the ‘Great Recession’ Of 2008-’09: A Pattern-Recognition’, Academy of Banking Studies Journal, 10 (2), pp.87-104.

Myers, S 2001, ‘Capital structure’, The Journal of Economic Perspectives, 15 (2), pp. 81-102.


Figure 1

Table 1: Descriptive Statistics

 Descriptive Statistics

Table 2: Results of the GLS Regression

Section A: Without a Recession

CSt0 + σ1ln TAt + σ2 (TAt -TAt-1)/ TAt-1+ σ3NIt/TAt + σ4FAt/TAt+ σ5VCSALESt+ σ6DEPt/TAt+ σ7MVt/BVt+et

Results of the GLS Regression

Section B: With Recession

CSt0 + σ1ln TAt + σ2 (TAt -TAt-1)/ TAt-1+ σ3NIt/TAt + σ4 FAt /TAt+ σ5VCSALESt+ σ6DEPt/TAt+ σ7MVt/BVt+ σ894D + σ901D+et

Results of the GLS Regression

Table 3: The Random Impacts of GLS Regression on Trade Creditors and Financial Debt

  1. CSt0 + σ1ln TAt + σ2 (TAt -TAt-1)/ TAt-1+ σ3NIt/TAt + σ4FAt/TAt+ σ5VCSALESt+ σ6DEPt/TAt+ σ7MVt/BVt+et
  2. CSt0 + σ1ln TAt + σ2 (TAt -TAt-1)/ TAt-1+ σ3NIt/TAt + σ4 FAt /TAt+ σ5VCSALESt+ σ6DEPt/TAt+ σ7MVt/BVt+ σ894D + σ901D+et

The Random Impacts of GLS Regression on Trade Creditors and Financial Debt

Table 4: Logit Regression Outcomes

Logit Regression Outcomes

Cite this paper

Select style


BusinessEssay. (2022, November 28). Impact of Recession on Capital Structure. Retrieved from


BusinessEssay. (2022, November 28). Impact of Recession on Capital Structure.

Work Cited

"Impact of Recession on Capital Structure." BusinessEssay, 28 Nov. 2022,


BusinessEssay. (2022) 'Impact of Recession on Capital Structure'. 28 November.


BusinessEssay. 2022. "Impact of Recession on Capital Structure." November 28, 2022.

1. BusinessEssay. "Impact of Recession on Capital Structure." November 28, 2022.


BusinessEssay. "Impact of Recession on Capital Structure." November 28, 2022.