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Geography and capital structure Xiaoqiao Wang Nanjing University Jin Wang Wilfr

Geography and capital structure Xiaoqiao Wang Nanjing University Jin Wang Wilfrid Laurier University Lewis Johnson* Queen’s University Abstract We investigate the impact of geographic location on ﬁrms’ capital structure decisions. We ﬁnd strong evidence that location of a ﬁrm inﬂuences its capital structure. In particu- lar, we ﬁnd that centrally located ﬁrms have lower leverage ratios than do remotely located ones. Moreover, consistent with the hypothesis that those remotely located ﬁrms face more severe adverse selection problems, the effect of geo- graphic location on capital structure is more pronounced when information asymmetry is higher. We further examine alternative explanations of the negative relation between ﬁrm geographic proximity and capital structure and show that the ﬁnancial constraint effect and industry clustering effect do not explain our results. Copyright © 2016 ASAC. Published by John Wiley & Sons, Ltd. Keywords: ﬁrm geographic location, information asymme- try, capital structure Résumé Dans cet article, nous étudions l’impact que l’emplacement géographique a sur les décisions relatives à la structure du capital des entreprises. Nos résultats indiquent très clairement que l’emplacement d’une entreprise inﬂuence sa structure du capital. Plus précisément, les entreprises situées au cœur des grands centres urbains ont des ratios de levier ﬁnancier plus faibles que celles qui sont situées dans les zones éloignées. Par ailleurs, suivant l’hypothèse selon laquelle les entreprises situées dans les zones éloignées sont confrontées à des problèmes de sélection adverse plus sérieux, l’étude montre que l’impact de l’emplacement géographique sur la structure du capital est plus prononcé lorsque l’asymétrie de l’information est plus élevée. Plus loin, nous nous penchons sur les explications possibles de la relation négative entre la proximité géographique d’une ﬁrme et la structure du capital et montrons que l’effet de la contrainte ﬁnancière et l’effet de regroupement de l’industrie ne rendent pas compte de nos résultats. Copyright © 2016 ASAC. Published by John Wiley & Sons, Ltd. Mots-clés : emplacement géographique d’une entreprise, asymétrie de l’information, structure du capital Modigliani and Miller’s (1958) capital-structure irrele- vance proposition shows that, with perfect capital markets, a ﬁrm’s capital structure has no effect on ﬁrm value. One of their assumptions is that information asymmetry does not exist between corporate insiders and outsiders. Relaxing this assumption, Myers and Majluf (1984) showed that a ﬁrm’s ﬁnancing decision should follow a pecking order. The pecking-order theory of capital structure predicts that when information asymmetry exists between managers and investors, ﬁrms should prefer internal ﬁnancing over external ﬁnancing. Moreover, when internally generated funds cannot cover investment needs, ﬁrms should issue debt. Equity issuance is the last resort for ﬁnancing, used only when debt capacity is exhausted. Myers and Majluf’s theory suggests that information asymmetry between insiders and outsiders is a key factor that determines ﬁrms’ capital structure decisions. Information asymmetry also intensiﬁes the agency problem, which also suggests a pecking order of ﬁnancing. Based on Jensen and Meckling’s (1976) agency theory and the fact that modern ﬁrms are characterized by separation of ownership and control, ﬁrms will choose internal funds over external funds to internalize managers’ private beneﬁts. We thank seminar participants at Queen’s School of Business, 2010 and the Northern Finance Association annual meetings, 2010. All errors are our own. *Please address correspondence to: Lewis Johnson is with School of Business, Queen’s University, 262 Goodes Hall, 143 Union Street, Kingston, Canada. Email: ljohnson@business.queensu.ca Canadian Journal of Administrative Sciences Revue canadienne des sciences de l’administration 35: 107–122 (2018) Published online 30 June 2016 in Wiley Online Library (wileyonlinelibrary.com) DOI: 10.1002/CJAS.1383 Can J Adm Sci 35(1), 107–122 (2018) Copyright © 2016 ASAC. Published by John Wiley & Sons, Ltd. 107 19364490, 2018, 1, Downloaded from https://onlinelibrary.wiley.com/doi/10.1002/cjas.1383 by University Of Sheffield, Wiley Online Library on [04/02/2023]. See the Terms and Conditions (https://onlinelibrary.wiley.com/terms-and-conditions) on Wiley Online Library for rules of use; OA articles are governed by the applicable Creative Commons License Also, debt is easier to issue at lower cost than equity as new shareholders will bear part of the agency costs while insiders will retain the beneﬁts. The agency problem results from the imperfect alignment of managers’ and shareholders’ interests, and will be intensiﬁed by severe information asymmetry. The amount and transparency of information are key factors for investors’ decisions. Evidence from extant studies (John, Knyazeva, & Knyazeva, 2011; Loughran, 2008; Malloy, 2005) suggests that distance increases information acquisition costs. To the extent that investors are concentrated in ﬁnancial centres and/or big cities, ﬁrms located in remote areas are likely to face a more severe information asymmetry problem because the long distance between these ﬁrms and ﬁnancial centres/big cities may hinder investors from acquiring information about those ﬁrms. In this study, we investigate how a ﬁrm’s geographic location, in particular, its distance to ﬁnancial centres/big cities, affects its capital structure decisions. Since it is relatively easier for investors to acquire and verify information about ﬁrms located near ﬁnancial centres/big cities, centrally located ﬁrms are likely to face a less adverse selection problem when they issue equities. As a result, everything else equal, centrally located ﬁrms are more likely to use equity as a source of ﬁnancing than are remotely located ﬁrms. Thus, we hypothesize that centrally located ﬁrms maintain a lower degree of leverage. Our empirical results strongly support the hypothesis that ﬁrms’ leverage ratios are positively correlated with their dis- tance to ﬁnancial centres/big cities. The results are statistically signiﬁcant. To further determine whether the effect of geo- graphic location on leverage is a consequence of an adverse selection problem, we examine how this effect is affected by ﬁrms’ information environment. We ﬁnd that our results are more pronounced when information asymmetry is high. Speciﬁcally, the effect of geographic location on leverage ratios is more pronounced for ﬁrms that are covered by fewer ﬁnancial analysts and that do not have a credit rating. One concern is that geographic location may be corre- lated with unobservable ﬁrm characteristics, which also affect capital structure. We use the Instrumental Variable approach to address this potential endogeneity issue. We use rent and administration expenses, which are closely related to ﬁrm location but not with leverage, as instrumental variables and apply two-stage least square regressions. Our results still hold robustly. We also exclude other explanations related to the capital structure decision and ﬁrm location. We show that rural ﬁrms are more ﬁnancially constrained than urban ﬁrms; thus, rural ﬁrms must face the difﬁculty of external ﬁnancing. This result is also conﬁrmed by additional regression tests controlling for cash ﬂows. Secondly, we exclude the industry clustering effect argued by Almazan et al. (2010) showing that ﬁrms located within an industry cluster will prefer to maintain relatively low debt ratios to attract opportunities for mergers and acquisitions. Our paper is closely related to the literature that examines how ﬁrms’ geographic locations affect corporate decisions. Loughran (2008) found that it is difﬁcult for rural ﬁrms that have a signiﬁcant information disadvantage to issue equity. Another study on geography and bondholders (Francis, Hasan, & Waisman, 2007) shows that rural ﬁrms exhibit signiﬁcantly higher costs of debt capital in compari- son to urban companies. Additionally, John et al. (2011) showed that rural ﬁrms issue more dividends and hold less cash to compensate for the asymmetric information costs for investors. However, previous studies do not focus on the geographic impact on capital structure. Our paper contributes to this literature by providing evidence that geographic location affects one of the most important corporate decisions—the capital structure choice. This paper is organized as follows. We next review the literature and develop our hypotheses. We then describe our sample and variables and provide descriptive statistics. Following that we present the principal empirical results and offer interpretations on the role of distance in capital structure. We then present the additional robustness test results and conclude with a discussion of the contributions and implications of our study. Literature and Hypotheses Earlier research has shown that geographic location of a ﬁrm could measure information asymmetry, and we have identiﬁed ﬁve factors in the literature about location and information environment. Location of ﬁrms may affect investors’ decisions, analysis quality, equity issuance, debt collection, and payout policy. Geographic proximity preference of investors is well documented. Coval and Moskowitz (1999) showed that geographic proximity preference contributes to the home bias phenomenon. They ﬁrst found that mutual fund managers tend to invest in securities geographically closer to them than the average security in their benchmark portfo- lio and that individual investors are even more biased toward local equities than institutional investors. Ivkovic and Weisbenner (2005) examined the stock investments of over 30,000 households in the continental United States from 1991 to 1996. They found that the average household invests 31% of its portfolio in stocks located within 250 miles while only 13% of the average household’s investments would be this close if investors had held the market portfolio instead. These home bias facts imply that companies located in central areas have more potential shareholders than ﬁrms located in remote areas. A possible explanation for preference for ﬁrms in central areas is that those ﬁrms have uploads/Finance/ can-j-adm-sci-2016-wang-geography-and-capital-structure.pdf