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«The Stock Market and the Financing of Corporate Growth in Africa: The Case of Ghana Charles Amo Yartey © 2006 International Monetary Fund WP/06/201 ...»

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The Stock Market and the Financing of

Corporate Growth in Africa:

The Case of Ghana

Charles Amo Yartey

© 2006 International Monetary Fund WP/06/201

IMF Working Paper

Research Department

The Stock Market and the Financing of Corporate Growth in Africa:

The Case of Ghana

Prepared by Charles Amo Yartey1

Authorized for distribution by Eswar Prasad

September 2006 Abstract This Working Paper should not be reported as representing the views of the IMF.

The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate.

This paper examines the corporate financing pattern in Ghana. In particular, it investigates whether Singh's theoretically anomalous findings that developing country firms make considerably more use of external finance and new equity issues than developed country firms to finance asset growth hold in the case of Ghana. Replicating Singh’s methodology, our results show that compared with corporations in advanced countries, the average listed Ghanaian firm finances its growth of total assets mainly from short-term debt. The stock market, however, is the most important source of long-term finance for listed Ghanaian firms. Overall, the evidence in this paper suggests that the stock market is a surprisingly important source of finance for funding corporate growth and that stock market development in Ghana has been important.

JEL Classification Numbers: G30, G32 Keywords: Stock markets, corporate finance, corporate growth, Ghana Author(s) E-Mail Address: CYartey@imf.org The author would like to thank colleagues at the University of Cambridge and the IMF, 1 especially Prof. Ajit Singh, Gianni De Nicoló, Kenichi Ueda, and Giovanni Dell’Ariccia, for useful comments and suggestions. The usual caveat for responsibility still applies.

-2- Contents Page I. Introduction

II. Theories of Corporate Finance

A. The Miller-Modigliani Theorem

B. Managerial Theory of Investment

C. Asymmetric Information Theory

D. Financial Constraint Theory

III. Corporate Financing Patterns Around the World

A. Flows of Funds Versus Balance Sheet Data

B. Corporate Financing Patterns in Advanced Countries: Stylized Facts

C. Corporate Financing Patterns in Developing Countries

IV. The Stock Market in Ghana

A. Historical Development

B. Main Characteristics

V. Methodology

A. Overview of the Ghanaian Corporate Sector

B. The Data

C. Variables

VI. Empirical Results

A. Testing for Measurement Bias in the Equity Financing Variable

B. Reconciliation of the Indirect Method with the Direct Method

VII. The Results in Comparative Perspective

VIII. Summary and Conclusions

Appendix I. Definition of Variables Used in the Analysis



1. Sources of Financing of Growth. 1992–96

2. The Size of the Ghana Stock Exchange

3. The Liquidity of the Ghana Stock Exchange

4. Ghana Stock Exchange: Turnover Ratio


1. Net Sources of Finance for the Corporate Sector

2. Singh’s 1995 Results: Top Listed Companies in Manufacturing, Mean Proportion of Internal and External Finance of Corporate Growth

3. Stock Market Development in Selected African Countries, 1996–2002.................. 25

4. All Non-Financial Listed Companies: Percentile Distribution of Indicators of Corporate Size and Growth

5. All Non-Financial Listed Companies: Percentile Distributions of Indicators of Financing of Corporate Growth

6. All Non-Financial Listed Companies: Percentile Distribution of Indicators of Capital Structure

7. All Non-Financial Listed Companies: Percentile Distribution of Indicators of Profitability and Stock Market Variables

8. All Non-Financial Listed Companies: Percentile Distribution of Changes in the Rates of Return

9. Listed Companies: Financing of Corporate Growth: The Direct Method................. 31

10. Financing of Corporate Growth in Ghana: Reconciliation of the Indirect Method with the Direct Method

11. Zimbabwe: Listed Companies’ Gross Sources of Finance, 1990–99

12. Developed Markets: Change in Total Assets, by Source of Financing, 1995–2000. 33

13. Emerging Markets: Change in Total Assets, by Source of Financing, 1995–2000... 34

14. Financing of Corporate Growth: Ghana and Other Emerging Markets Compared ( Mean Values, in percent)………………………………………………………...35

–  –  –

Over the past few decades the world stock markets have surged and emerging market countries have accounted for a large amount of this boom. The growth of stock markets in emerging markets has reflected the increased demand for such transactions and the lower cost of investing in international financial markets. Although most emerging markets are in Latin America and Asia, recent years have seen a number of new stock markets in African countries such as Ghana, Malawi, Swaziland, Uganda, and Zambia. The establishment of stock markets is expected to promote economic growth and development by increasing the savings rate and increasing the quantity and the quality of investment. At the micro level such effects can be addressed in terms of the impact of the stock market on corporate finance.

Strangely enough, the corporate finance contribution of the stock market in developing countries has received little systematic attention in financial and development economics. A pioneering study for the International Finance Corporation by Singh and Hamid (1992) finds that corporations in developing countries finance their growth mainly through external finance and new issues of equity. This result has been used to argue in favor of investing heavily in stock market development in African countries.

This paper examines the financing practices of Ghanaian firms based on their balance sheets.

In particular, it investigates whether Singh’s theoretically anomalous findings that developing country firms make considerably more use of external finance and new equity issues than developed country firms to finance asset growth also hold in the case of Ghana.

To consider the corporate financing contribution of the stock market, we compare the relative importance of internal financing, external debt financing, and external equity financing in explaining the growth of total corporate assets (Glen and Singh, 2003). To put our empirical results in perspective, we compare it with recent works on corporate financing patterns in other developing countries.

There are several reasons why it would be interesting to know the prevailing financing patterns in Ghana. First, knowing the financing pattern in Ghana can help policymakers to fully understand how their national financial system functions if they wish to improve its functioning and thereby serve their national business community. Second, corporate investment is an important part of total investment. It is clearly important to understand the financial aspects of the decisions corporations make about investment. The importance of private investment, however, goes beyond its actual weight in the data. With the private sector now carrying a heavy burden in generating economic growth in African countries, it is important to understand the financial mechanisms it can use in shouldering this responsibility. Last, there are links between corporate behavior and macroeconomic stability.

Corporations that carry heavy debt burdens can pose a threat to the health of their creditor financial institutions. In addition, high levels of indebtedness can exacerbate macroeconomic instability by increasing the sensitivity of economies to economic shocks (Mayer, 1990).


–  –  –

The early neoclassical view of finance was dominated by the Miller-Modigliani theorem.

According to this theorem, if firms and investors have the same financial opportunities then under conditions of perfectly competitive financial markets, no asymmetries of information between different agents, and the same tax treatment of different forms of finance, corporate financial policy is irrelevant. The theory established that, the stock market valuation of a firm is based exclusively on the earning prospects of the firm and not on its capital structure. In effect, internal and external finance are viewed as substitutes. Firms could use external finance to smoothen investment when internal finance fluctuates.

B. Managerial Theory of Investment

The fundamental determinant of investment in the managerial theory is the availability of internal finance. Managers are envisaged as pushing investment programs to a point where their marginal rate of return is below the level that would maximize shareholder welfare. In other words, managers indulge in over-investment. For this purpose, internal finance is particularly favored since it bypasses the capital market and is most amenable to managerial desires for growth. Stated differently, professional managers avoid relying on external finance because it would subject them to the discipline of the stock market. In contrast, the level of cash flow is irrelevant for the firm’s investment decisions in neoclassical theory;

what matters is the cost of capital.2

C. Asymmetric Information Theory

Myers and Majluf (1984) argued that corporate capital structure is designed to offset inefficiencies in the firm’s investment decisions that are caused by information asymmetries.

They show that if managers have information that investors do not have then the market may misprice equity. If firms are required to finance new projects by issuing equity, underpricing may be so severe that new investors may capture more than the net present value of the project resulting in a loss to the existing shareholders. Under this situation positive net present value projects would be rejected. This problem can be avoided if the firm can finance the new project by issuing securities that are not severely undervalued by the market. Internal finance has no such undervaluation and is preferred to debt and equity. This is Myers ‘pecking order’ theory of finance.3

–  –  –

Firms generally might finance their investment activities by internal cash flows or external funds. Under the assumption of perfect capital market, it does not matter whether firms finance their investment activities by internal or external funds. There is no financial constraint for profitable investment projects because the adjustment of interest rate would equate supply and demand for funds, in the case of internal funds. However, with capital market imperfection, firms cannot obtain external funds on the same conditions as internal funds. This is especially the case for small businesses or firms in new growth industries, which depend on loans from banks as the only available source of external finance (Gertler and Gilchrist, 1994). These firms are bank dependent because they cannot easily switch to commercial papers or the equity market if there is no available credit. Therefore, the extent and the terms to which external finance is provided affect corporate investment and real economic activity (Greenwald and Stiglitz, 1993).

–  –  –

As pointed out by Mayer (1988), there are two sources of information for studying aggregate corporate financing patterns in different countries. The first is national flow of funds statement that records flows between different sectors of an economy and between domestic and overseas residents. The second source is company accounts that are constructed on an individual firm basis but are often aggregated or extrapolated to industry or economy levels.

Both sources have their advantages as well as limitations.4 Theoretically, flow of funds statistics provide a comprehensive coverage of transactions between sectors because they cover all sectors in the economy, and are collected in ways, that are largely comparable between countries. The problem with flow of funds data is that they capture only flows of funds from one economic sector to another and thereby eliminate entirely intra-sectoral flows. Company accounts are only available for a sample, often quite small, of a country’s corporate sector. However, the data that are employed in company accounts are usually more reliable than flow of funds. More specifically, flows of funds are constructed from a variety of different sources that are rarely consistent. As a result, statistical adjustments are required to reconcile entries.

A fundamental distinction between flow of funds statistics and company accounts is that flow of funds only relates to domestic activities while company accounts are constructed on a worldwide basis including foreign subsidiaries. Company accounts are, therefore, more projects will tend to be financed mainly from internal sources or proceeds of low risk debt issues. Finally, debt-equity ratio increases with the extent of informational asymmetry.

4 See Corbett and Jenkinson (1996) for a comparative discussion of using flow of funds and company accounts.

-7suitable for analyzing how different countries’ corporate sectors fund themselves, but flow of funds allows the contribution of a domestic sector’s financial system to be identified.

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