The Impact of Financial Structure on the Performance of European Listed Firms

1. Introduction In the last years we have witnessed the development of financial theories that reveal the importance and the impact of financial structure on the performance. Modigliani and Miller (1958) are the first that have tentatively studied the impact of capital structure. In their studies they demonstrate that the value of a firm is independent of its capital structure and consequently there is no correlation between leverage and firm's value in a world without tax and transactions costs. After five years, the authors have revealed the positive impact of leveraged firms in the case of tax deductible on interests' payments. Under this condition, the firms should increase the debt to full the value by maximizing the interest tax shield. After the development of the irrelevant works of Modigliani and Miller many other theories have been trying to explain the impact of capital structure such as the pecking order theory, the free cash-flow theory, the trade-off theory and the agency cost theory. Through the agency cost theory, Jensen and Meckling (1976) propose the usage of debt as a disciplinary tool to ensure the performance of managerial staff specifically when control and ownership are separated. Thus high debt ratio leads to reduce the free cash-flow waste by managers (Jensen, 1986). Stulz (1990) confirms this concept by indicating that the reduction of free cash-flow may decrease the level of profitable investments. Under these opposite situations, firms have to adjust dynamically their capital structures against the adjustment of benefits. Accordingly, the trade-off theory (Myers, 1984) states that the benefits and costs of financial sources must be traded off until the benefits of debts are offset the costs of debts. In 1997, Myers presented a model in which he stated that debt may cause underinvestment in future opportunities, specifically when debt-holders capture all the return of the investment while shareholders bear most of the cost. In this situation debts will have a negative impact on firm's value by creating a conflict between shareholders and debt-holders. Therefore, Myers suggests the usage of short-term debt due to its maturity before the investment decision. Baltas et al. (2013) suggested a PVAR methodology for liquidity creation. The packing order theory (Myers and Majluf, 1984) comes to complicate the evidence of capital structure by indicating that firms should finance their investments in a hierarchal method using the retained earnings followed by external financing. When external financing is required, debt will be preferred before issuing new equity. La porta et al. (1998) and Claessens et al. (2000) highlight the complexities of managing the capital structure by considering the macro environment system such as the legal protection which can explain why some firms are financed differently in different countries. For the authors a high level of regulation and legal protection may influence agency conflicts by recognizing many constraints to external financing. Oppositely, a low level of protection and regulation may increase the level of expropriation through the external financing. Based on the contradictory results, we will study in this paper the interaction between capital structure and the performance of European listed firms by considering the different regimes of legal protection. This provides an opportunity to investigate if the macro environment system in Europe rises as determinant key for the financial behaviour. Moreover, it helps to renew the debate on capital structure based on new data extracted at the end of 2012. Therefore, the main purpose of this study is to evaluate the complex impact of the capital structure on the performance of European listed firms. The second purpose is to explore if there is any impact of the country's legal system on the financial behaviour. To address this issue, we begin this study by exploring the different regulations in Europe. …