Religion and Capital Structure

Religion and Capital Structure Saeed Algahtani* M. Kabir Hassan**

Abstract We investigate the relation between Islamic culture and capital structure. Our sample comprises 498 firm-year observations on 126 unique Saudis non-financial firms. We apply our study in Saudi Arabia, because it has an ideal environment to conduct this empirical study. We use the fixed effect model. The presented empirical result suggests an economically and statistically significant negative relationship between the Islamic culture and the capital structure.

Keywords Islamic culture; capital structure; culture

*Department of Economics and Finance, University of New Orleans Email: [email protected] **Department of Economics and Finance, University of New Orleans, New Orleans, LA 70148 Phone: 504-280-6163 Fax: 504-280-6397 Email: [email protected]

Introduction The capital structure has gain a lot of attention from researchers since the work of Modigliani and Miller in 1950s, since it maximizes the firm’s value by reducing the cost of capital at the optimal capital structure. However, most of these papers try to study intensely the relationship between some firm characteristics and the determination on the levels of debt and equity ratios. Therefore, most of them discuss only the management side, and ignore the behavior or social characteristic side of this phenomena. However, many research in the behavioral finance field recently find that the behavior or social characteristic side does matter in the process of determining the optimal capital structure and eventually for the firm’s value. Consequently, this paper will be the first to discuss the effect of Islamic culture on capital structure. Guiso, Sapienza, and Zingales (2006) defined culture as “those customary beliefs and values that ethnic, religious, and social groups transmit fairly unchanged from generation to generation. Stulz and Williamson (2001), defined culture as a system of beliefs that shape the actions of individuals within a society, can help explain differences in investor protection. Consequently, the effect of culture changes the way of people’s life around the world, and at the end managers or directors will be affected when they make their decision on debt maturity choices and capital structure in international level. Therefore, I believe culture can be seen is one aspects of the behavioral finance. Islamic culture is a term primarily used in secular academia to describe the cultural practices common to historically Islamic people. In the other hand, debt is an important part of financing the firms’ assets or capital structure, in order to reduce the cost of capital, and

maximize the firm’s value eventually. However, Islam takes the matter of debt very seriously and warns against it and urges the Muslim to avoid it as much as possible and work instead. This paper attempts to explain the effect of Islamic culture on the capital structure. Our sample comprises 498 firm-year observations on 126 unique Saudis non-financial firms in Saudi Stock Exchange (Tadawul) during 4 years from 2012 to 2016. We hypnotized that there is a negative relationship between of the Islamic culture and the capital structure. Our results support this premise. We examine the Saudis non-financial firms in Saudi Stock Exchange for several important reasons. First, Saudi Arabia has a majority Muslim population, and it is known for its strong loyalty to Sharia law, which gives us the opportunity to examine the effect of religious beliefs and culture on the capital structure. Second, in Saudi Arabia, Islamic finance scholars voluntarily screen stocks and financial instruments for their Sharia compliance and try to distribute this information to the public through unofficial channels. Third, Saudi Arabia alone owns the largest amount of sharia compliant fund assets worldwide with 52 % of the global Sharia-compliant fund assets (Merdad, Kabir, and Khawaja (2015)). This enables us to study the effect of Islamic culture on the capital structure. As result, these reasons make Saudi Arabia an ideal environment to conduct this empirical study. Also, the Saudi financial market environment has some special characteristics such as the absence of a corporate tax, a vague bankruptcy law, and a and illiquid bond market. Our motivation is to help multinational managers to be familiar with this relationship between of the Islamic culture and the capital structure. More important, this paper adds to the growing literature on Islamic finance by showing the effect of Islamic culture on the capital structure and the role of Sharia compliance in the Saudi market.

This paper will be presented as fallow: literature review, data and methodology, empirical results, and conclusion. Literature Review

In this section, I will present the previous literature of culture, Islamic culture, and capital structure. First, capital structure has gain a lot of attention from researchers since the work of Modigliani and Miller in 1950s, and literatures have been discussed this topic intensively. Thus, I will briefly present the previous literature in this topic. Academic research work on capital structure, both theoretical and empirical, has generated many discussions to clarify why firms do what they do regarding choosing debt or equity. In this regard, the studies on capital structure can be classified into three main categories First, the capital structure gained increased inspection in the literature since the work of Modigliani and Miller in 1950s. The literature suggest that the firm’s capital structure is basically a tradeoff between benefit and cost of debt. Jensen and Meckling (1976) introduced the “agency theory” and provide this classic argument for the trade-off between bankruptcy cost, tax benefits, and agency cost related to asset substitution. Modigliani and Miller (1963) extend the basic propositions in their original article by allowing for a corporate profit tax with considering the deductible interest payment. In the other hand, Miller (1977) extends the theoretical consideration of capital structure to personal taxes. As result, he extends the M&M model to consider the effects of personal taxes. He argues that the M&M model of corporate taxes exaggerates the advantages of corporate debt financing without considering the personal taxes effects.

Myers (1984) introduced the preference ranking over financing sources to minimize the adverse selection cost which is known as pecking order theory. Also, under the signaling theory, Myers and Majluf (1984) suggest that firms may increase their debt, to signal the market about their expected bright profitability in the future. Stewart C. Myers (1984), tries to study how do firms choose their capital structures. Myers states that in his introduction, they do not know how firms finance their assets, is it by debt, equity, or both? Also, the author states that they have only recently find out that capital structure changes send information to investors. He claims that their theories about the optimal capital structure don't appear to describe the real financing behavior, because the poor understanding of corporate financing behavior and its effects on security returns by the time of his study. Also in his introduction, Myers states that his goal is to establish new directions for the future research on capital structure. Masulis (1980), examine the price adjustments in firms’ common stock, preferred stock and debt related to these announcements. He states that the leading theories of capital structure assume two valuation effects in capital structure change: a corporate tax effect and an expected cost of bankruptcy effect. In the determinants of the capital structure, many articles try to find the most significant determinants of the capital structure. For instance, Rajan and Zingales (1995), examine the Group of Seven countries G7 and the find that the dominant factors are: market to book ratio, tangibility, profit, and size. Moreover, Frank and Goyal (2009) document that the key factors for U.S firms are: industry leverage, market to book ratio, tangibility, firms size, firm size, inflation. Also, Ozde (2015) find the most factors of capital structure are size, industry leverage tangibility, profitability, and the inflation.

Graham, Leary, and Roberts (2015) state that before World War II leverage amongst unregulated firms was equally stable and low. After World War II to 1970, leverage increased significantly, but after 1970, leverage has continued to be stable. The increase in financial leverage was because of an increase in long-term debt Also, Graham, Leary, and Roberts (2015) state that Much of the increase in leverage over this period was because of the replacement of debt for preferred equity. This shift toward a greater dependence on debt as a funding source resulted from the positive change in corporate tax rates, the growth of financial intermediaries, and a large reduction in government borrowing. Also, Graham, Leary, and Roberts (2015) find no significant positive relationship between tax rates and aggregate leverage. Michael J. Barclay and Clifford W. Smith (2005) state that the many theories of capital structure have led to different and to competing decisions and results. For example, some theorists argue that neither capital structure nor dividend policy has more influence on corporate market value. Another theorist suggest that finance managers main emphasis is to balance the tax shields of larger debt against hypothetically large costs of financial distress. However, another theorist suggest that financing decisions are mainly concerned with signaling effects, which are established by the reduction in stock price in response to an announcement of common stock offerings and the increase in stock price in reply to leveraged recapitalization. In regard to Saudi Arabia, Alzomaia (2014) investigates the capital structure of Saudis firms, using firm data to study the factors of leverage. His result suggests that there is a positive relationship between leverage and size, growth. On the other hand, his results show that there are negative relationships between leverage and tangibility of assets.

Second, the psychology and sociology literature discuss culture to explain differences in business at international level. For instance, Yaw M. Mensah (2012), state that most researchers have been using cultural to explain differences in leadership attributes, work values and work attitudes. Moreover, Stulz and Williamson (2003) suggest that cultural differences impact creditor rights, and their result indicates that cultural differences lead to differences in national culture and market behavior. The literature provided many proxies to measure culture, for instance, Knack and Keefer (1997) use levels of trust as proxy for culture to test international differences in trust and civic norms. Their result suggests that in nations with higher levels of trust and civic norms, economic performance is stronger. Further, La Porta, Lopez-de-Silanes, Shleifer, and Vishny (1999) use religion as a proxy for culture in their study of government quality. Also, Stulz and Williamson (2001), use language as proxy for culture, and they find that religion helps forecast the crosssectional variation in creditor rights better than a country's openness. Chui et al. (2010) propose that the cultural characteristics of a society may have real influences on the equity investment decisions of that society. He finds that individualism is positively associated with trading volume and volatility as well as the magnitude of momentum trading profits. However, Li et al. (2013) investigates corporate risk taking and shows that stronger corporate governance at the firm level mitigates cultural influences. Also, Fauver and McDonald )2015( find that the stronger the governance procedure turn out to be, the less noticeable this cultural effect becomes. Also, Fan, Titman, and Twite (2012), find that a country’s legal and tax system, corruption, and the preferences of capital suppliers explain significant part of the variation in leverage and debt maturity ratios.

Finally, there is not enough literatures to discuss Islamic culture. However, Barro and McCleary (2002, 2003) show that some religious beliefs such as beliefs in heaven or hell have a positive effect on economic growth. Also, Guiso, Sapienza and Zingales (2003), looked at the effect of religion on trust across individuals around the world using the World Values Survey. The result, indicates that If a person regularly attends religious services, the level of trust increases by another 20 %. Data and Methodology We examine a sample that comprise of 498 firm-year observations on 126 unique Saudis non-financial firms in Saudi Stock Exchange (Tadawul) during 4 years from 2012 to 2016. For our control variables, we consider only specific company factors such as size, growth, tangibility, and profitability. In this regard, we calculate the size by taking the log of the sale. Also, we calculate the change on sale as proxy for the firm’s growth. Moreover, the tangibility is calculated as the fixed assets divide by the total assets. Also, we scaled the net income by the total assets to calculate the profitability. Finally, we added the debt maturity, as the percentage of the long debt in the total debt. The main independent variable is the (pure) which is a dummy variable as proxy for Islamic culture, takes 1 value with sharia compliant firms and zero otherwise. We used Alosaimi’s1 list to classify the sample based on sharia or non- sharia compliant firms. In the other hand, the dependent variable is the leverage ratio, and it is a proxy for the capital structure. Following Oozed 2015, we calculated leverage ratio by dividing the total debt by the total assets.

1

Dr. Muhamad Alosaimi made a list of sharia and non- sharia compliant firms in Saudi market) to separate between firms in Saudi market according to sharia complaint loan and activity. I have collected the data manually from his website: http://almaqased.net/

Table 1 Descriptive Statistics The sample comprises 498 firm-year observations on 126 unique Saudis non-financial firms in Saudi Stock Exchange (Tadawul) over 2012 - 2016. Detailed variable definitions are in Appendix A. Variable Leverage (%) Size Growth (%) Tangibility (%) Profitability (%) Debt Maturity (%)

Obs 498 498 498 498 498 498

Mean 0.406 13.799 0.044 0.467 0.066 0.162

Median 0.395 13.863 0.000 0.470 0.055 0.113

Std.Dev. 0.215 1.692 0.500 0.233 0.091 0.153

Min 0.030 6.435 -0.999 0.000 -0.348 0.000

Max 0.960 19.057 8.590 0.932 0.467 0.684

Table 1 shows summary statistics for the full sample without classifying the sample into sharia or non- sharia compliant firms. The sample comprises 498 firm-year observations on 126 unique Saudis non-financial firms in Saudi Stock Exchange (Tadawul) during 4 years between 2012 and 2016. The median of Leverage ratio, defined as total liabilities divided by total assets, is 39.5% and it is very close to the mean. Thus, the sample is symmetrical around its center. The median of debt maturity ratio, defined as total liabilities scaled by total assets, is 11.3% which is lower than the mean 16.2% by about 5%. Table 2 shows summary statistics for sharia compliant firms. The mean (median) of the leverage of these firms is 27.7% (24%) which is lower than the mean (median) of the full sample which is 40.6% (39.5%) as presented in Table 1. Therefore, the sharia compliant firms show a tendency of lower leverage ratio. Also, Sharia compliant firms show a higher profitability ratio with average of 9.1% compared to 6.6% of the total sample as presented in Table 1. Moreover, the debt maturity ratio is 8.8% which is about the half of the debt maturity of the total sample 16.2%.

Table 2 Descriptive Statistics The sample comprises 217 sharia compliant firms-year observations on 59 unique Saudis non-financial firms in Saudi Stock Exchange (Tadawul) over 2012 - 2016. Detailed variable definitions are in Appendix A. Sharia Compliant Firms Variable Obs Mean Median Std.Dev. Min Max Leverage (%) 217 0.277 0.240 0.175 0.030 0.740 Size 217 13.317 13.672 1.461 9.135 17.042 Growth (%) 217 0.037 0.000 0.354 -0.797 2.473 Tangibility (%) 217 0.452 0.460 0.234 0.000 0.932 Profitability (%) 217 0.091 0.076 0.098 -0.159 0.467 Debt Maturity (%) 217 0.088 0.066 0.091 0.000 0.436

Furthermore, the standard deviation of the growth ratio in the sharia compliant firms is 35.4% which is lower than the same ratio in the total sample by - 29.3%. Thus, the growth ratio of the sharia compliant firms is more stable comparing to the same ratio in the total sample. Table 3 Descriptive Statistics The sample comprises 36 non- sharia compliant firms-year observations on 13 unique Saudis non-financial firms in Saudi Stock Exchange (Tadawul) over 2012 - 2016. Detailed variable definitions are in Appendix A. Non- Sharia Compliant Firms Variable Obs Mean Median Std.Dev. Min Max Leverage (%) 36 0.631 0.675 0.168 0.030 0.860 Size 36 14.904 14.823 1.607 9.892 17.809 Growth (%) 36 0.039 -0.021 0.345 -0.503 1.126 Tangibility (%) 36 0.561 0.593 0.219 0.000 0.862 Profitability (%) 36 0.014 0.018 0.037 -0.091 0.076 Debt Maturity (%) 36 0.357 0.416 0.198 0.001 0.684

Table 3 shows summary statistics for the non-sharia compliant firms. The results indicate that the leverage ratio of the non-sharia compliant firms is about the double of the ratio of the counterpart firms. The mean (median) of the leverage of these firms is 63.1% (67.5%) which is higher than the mean (median) of the sharia compliant firms which is 27.7% (24%) as presented in Table 2. Also, the debt ratio shows that the 35.7 of the total liabilities of the non- sharia

compliant firms are a long-term liability. Furthermore, the profitability ratio of non-sharia compliant firms is 1.4% while it is 9.1% in the counterpart firm. Table 4 The correlation matrix This table test the correlation to between variables to detect the multicollinearity with 413 obs Detailed variable definitions are in Appendix A.

LEV size growth tang profit Debtmaturity pure notpure

LEV

size

0.553* 0.041 0.198 -0.321 0.693** -0.530* 0.363

0.032 0.136 0.186 0.451* -0.285 0.212

growth

0.035 0.019 0.010 -0.033 -0.009

tang

0.015 0.429* -0.105 0.113

profit

-0.279 0.293 -0.176

Debtmaturity

-0.474* 0.417*

The result of the correlation matrix in table 4, suggest the highly negative correlation (0.530) between the Islamic culture (PURE) and the capital structure (LEV). Also, it shows the high positive correlation between leverage and debt maturity (0.693). Also, there is a high positive correlation between leverage and size with 0.553. Table 5 shows that there is enough evidence to reject the null hypothesis and conclude that there is a difference between sharia compliant firms and non-sharia compliant firms in means for the all variables except the growth rate.

Table 5 This table shows the two sample t test assuming unequal variances for each Variable in this paper. Detailed variable definitions are in Appendix A. The null hypothesis is that the two population means are the same but the two population variances may differ. LEV size growth tang profit Debtmaturity Sharia Compliant Firms 0.277 13.317 0.037 0.452 0.091 0.088 Non- Sharia Compliant Firms 0.631 14.904 0.039 0.561 0.014 0.357 Difference in means -0.353 -1.587 -0.001 -0.109 0.077 -0.269 T-test P-value

-11.607 0.000

-5.556 0.000

-0.024 0.981

-2.725 0.009

8.465 0.000

Table 5 shows results of the estimates from the Fixed Effect Model. The sample contains 122 Saudi Firms listed in the Saudi Stock Exchange for the 2013-2016 period, and in the Alosaimi’s list for the same period. The leverage ratio was regressed against four independent variables: size, profitability, debt maturity, and sharia compliant firms. Lastly, the difference in mean for the profitability between the sharia compliant firms and non-sharia compliant firms is very high and significant at 1% level with value of 7.7%. In this regard, this will raise a question about the reasons of profitability of sharia compliant firms in Saudi Arabia for future research. Empirical Results Table 6 shows the estimated model by using the fixed effect model, to overcome the firm specific effects. The coefficient of our main variable (pure), the proxy of the Islamic culture, has a negative value at 1% significant level. Therefore, our empirical result suggests an economically and statistically significant negative relationship between the Islamic culture and the capital structure. For size and the tangibility, there is a positive significant relation with leverage. Also, for the profitability, there is a negative relationship with leverage ratio. The estimated model 𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒 (firmi,t ) = 𝛼 + 𝛽1 Ln (size) + 𝛽2 profitability + 𝛽3 tangibility - 𝛽4 (pure) sharia compliant firms + 𝜀𝑖,𝑡

-8.030 0.000

Table 6

The Model Summary and Regression Results This table shows results of the estimates from The Fixed Effect model . The sample contains 122 Saudi Firms listed in the Saudi Stock Exchange for the 2013-2016 period. The leverage ratio was regressed against four independent variables: size, profitability, debt maturity, and sharia compliant firms. Variable

size tang profit pure constant

Coef. Std. Err. 0.025 0.008 0.156 0.052 -0.148 0.070 -0.055 0.011 0.002 0.111

t 3.190 3.000 -2.120 -4.870 0.020

P>|t| 0.002 0.003 0.035 0.000 0.985

[95% Conf. Interval] 0.010 0.041 0.053 0.258 -0.285 -0.010 -0.078 -0.033 -0.216 0.220

𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒 (firmi,t ) =0.002 + 0.025 Ln (size) - 0.148 profitability + 0.156 tangibility – 0.055 (pure) sharia compliant firms. The negative significant relation between (pure) and leverage is not due to the Alosaimi classification, since it is not based on the low leverage, but instead it is based on the type of loan and activity (must be free of interest loans and forbidden activities). However, there is possibility that the debt channel of sharia compliant firms is limited. In further work , we need to consider this issue in our analysis in robustness check in the future .

Conclusion

We investigate the relation between Islamic culture and capital structure. Our sample comprises 498 firm-year observations on 126 unique Saudis non-financial firms. We use the fixed effect model. The presented empirical result suggests an economically and statistically significant negative relationship between the Islamic culture and the capital structure.

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