EFFECTS OF CAPITAL STRUCTURE CHANGES ON SHARE PRICES IN SINGAPORE : 1975-1988

Abstract

Since Modigliani and Miller (1958) pioneered analytical studies on capital structure, different propositions have been put forward by various theorists. Modigliani and Miller (1963) presented the argument that with the existence of the tax-shield effect of debt, a firm's value can be maximized by total debt financing. Other authors have argued that the rising risks of bankruptcy, and thus increasing costs of distress from expanded debt, would result in an optimal capital structure for the firm. Miller (1977) however concluded that when corporate and personal taxes are taken into consideration, the value of the firm would be invariant to changes in capital structure. There have been many studies on the share price reactions of firms which experienced capital structure changes in the American and British markets. Some of these studies also analyzed the importance of the tax-shield effect of the leverage changes with conflicting results having been recorded so far. However, no similar studies have been reported in developing capital markets such as in Singapore. This study made use of the existence of taxed and tax-exempted (i.e. exempted from corporate tax and personal tax on dividends) firms listed on the SES to determine if tax-shield effect arises from leverage changes. Comparisons were made on the difference in abnormal returns of the two classes of firms at the time of rights issues (which reduce leverage) and increases in debt from dividend payments when earnings are constant. Bonus issues were also analyzed to provide a benchmark description of price reactions of the different classes of securities to leverage-neutral events. Sample 1 in our tests is made up of 36 bonus issues from tax-exempted firms and Sample 2 comprised 147 similar issues from taxed firms. Samples 3 and 4 (with equal risks) consisted of 18 and 35 rights issues from taxed and tax-exempted firms respectively, while 37 dividend increases each from the two classes constituted Samples 5 and 6 which also have equal risks. The mean difference in the value as a result of rights issues was also tested. Although the three events resulted in significant positive abnormal returns for the samples (due to information effects), no significant difference was recorded between the taxed and the tax-exempted portfolios for all the events tested as would be expected if a tax-shield effect was present. This suggests an apparent lack of importance of the tax-shield effect of debt as a result of leverage changes. A secondary conclusion was that the "good news" effect of the capital structure changes dominated the tax-shield effect (even if the latter existed). The lack of a significant difference in the change in value of the firms to leverage-reducing events (rights issues) also supported these findings.