The competitive power of capital structure in a tourism destination

Yusuf Bubutunde Adeneye, Ei Yet Chu and Fathyah Hashim

Introduction

In the extant literature on strategic management, there is a considerable support for certain factors that determine the competitive forces and advantage of the firm. Among these factors are structural forces (Birkinshaw et al., 1995), information technology and governance (Dehning and Stratopoulos, 2003; Raymond et al., 2019), supply chain capabilities (Yusuf et al., 2004) and high involvement work practices (Guthrie et al., 2002). A critical examination of these studies revealed that much attention is placed largely on business and innovation processes, supply chain, production function, external environmental factors and marketing processes in formulating and implementing competitive strategies. However, one area that has received less attention is the financial strategy/policy of the firm within the context of a tourism destination.

A large number of past studies on tourism strategies have focused on coopeti-tion (Damayanti et al., 2019; Della Corte and Aria, 2016), destination environmental conditions (Lee and King, 2006; Martinez-Roman, et al., 2015; Mihalic, 2016), sustainability’ (Boskov et al., 2018; Mihalic, 2016) and international trade (Fuster et al., 2018; Hong, 2009). While these studies focused largely’ on external factors, there is a literature gap in relation to corporate financing or financing structure as a contextual factor that influences the level of competitive strategy’ in the tourism sector. Consequently, the use of corporate finance theories, such as trade-off and pecking, has received less theoretical and practical analyses to explain the level of tourism destination strategies. Therefore, while most of the works on tourism performance placed emphasis on competitive strategies, there is a limited understanding of the level to which tourism financial performance might be influenced following tourism firms’ strategy' response to a changing capital structure.

The heterogeneity of capital structure in the tourism sector is increasing daily' as competition in the tourism sector becomes more dynamic. Eccles (1991) stated that a firm’s corporate system depends largely' on its financial decisions that may’ undercut its strategy for competitive advantage. The financial strategy of corporate firms can serve as a sea change strategy that influences the firm’s strategic choice and priorities by practising leverage recapitalization and taking additional

The competitive power of capital structure 2 39 debt, often in excess of the firm’s optimal debt capacity (Eccles, 1991). Thus, a firm’s drive for competitive advantage depends on its financing policy.

According to the Phillips et al. (2017), tourism-related investment is locked in fierce competition for investment inflows and access to credit and finance attracts investment in the tourism sector while increasing the level of competition within the industry. Barriers to the tourism investment can also shift the nature of competition between large and small firms. While large firms have the capacity to overcome finance barriers, thereby obtaining monopoly status, similar barriers pose high costs on small firms that have less access to finance, thus impeding their competitiveness and stifling innovation. USAID (2017) submitted that grants, equity financing and debt financing are the three financing approaches that can promote sustainable tourism projects. This implies that there are risks and returns that firms and other players in the tourism industry must consider in designing and changing their competitive strategics. The lower the risk of financing, the shorter the maturity of debt financing and the lower the cost of capital will be.

Bangladesh has some unique tourist centres and destinations that can give better experiences and quality services to tourists. However, the country’s tourism competitiveness ranking is declining among other countries of the world and even among their counterparts in the Southeast and Southern Asia regions. Bangladesh is ranked poor in key indicators of travel and tourism competitiveness index (see Table 14.1). Bangladesh is ranked 111th in total travel and tourism government expenditure, ranked 51st in travel and tourism industry GDP, ranked 113th in travel and tourism industry share of employment, ranked 130th in travel and tourism policy and conditions and ranked 135th in travel and tourism sustainable development, despite the fact that the industry ranked high, 15th in its travel and tourism industry employment. Low competition has been related to finance and strategy (Dwyer, 2018; Chen et al., 2018; Zhou, 2019). In addition, evidence has shown that firms that depend largely on sales, profitability and retained earnings face intense tourism competition (Verreynne et al., 2019; Bakker, 2019; Carrillo-Hidalgo and Pulido-Fernandez, 2019). Therefore, we conjecture a practical and theoretical link between competitive strategy, financing decisions and performance.

This chapter examines the relationship between capital structure, competitive strategies, and financial performance among tourism firms in Bangladesh. It contributes practically and theoretically. First, we found that internal factors such as corporate financing have significant effects on firms’ competitive strategies in tourism destination rather than innovation and information and communication technologies (ICT) as documented by previous studies. We found that firms’ level of differentiation strategy is declined by high debt financing while it encourages cost leadership strategy. Second, we establish that trade-off theory and pecking order theory partially support the level of competition in tourism destinations. While trade-off' theory supports the cost-leadership strategy, the pecking order supports the differentiation strategy. Third, our findings have practical implications for tourism stakeholders such as government and regulators to consider access to

Table 14.1 Travel and Tourism Competitiveness Index indicators

Source: World Economic Forum and International Finance Corporation, 2017

Note: T&T GE = T&T Government Expenditure, T&T IE = T&T Industry Employment (1,000 jobs), T&T iGDP = T&T Industry GDP (USS million), T&T ISE = T&T Industry Share of Employment (% of total employment), T&T is GDP = T&T Industry Share of GDP (% of total GDP), T&T PC = T&T Policy and Conditions subindex, 1-7 (best), T&T SD = Sustainability of Travel and Tourism Industry Development, 1-7.

This chapter is organized as follows. The first section presents the research gap, the significance of capital structure as a new strategy paradigm in the tourism sector and the contribution of the study. Next, the chapter presents the literature review and the hypotheses formulated. The third section presents the methodology of the study, while the fourth presents the data analysis and the discussion of results. The last section concludes the study.

Literature review

Theoretical foundation

The moderating effect of capital structure on the relationship between competitive strategy and profitability is closely related to the theory of pecking order and trade-off theory. First, the trade-off theory posits that the benefits of debt equal the costs of debt. The use of debt determines the value of the firm, and the value of the firm is also a function of competitive strategy. Therefore, debt financing would reflect the nature of competitive strategy of firms and organizations. Firms with good credit ratings and financial indicators have more access to debt than their counterparts. Theoretically, firms can invest well and heavily in any competitive strategy in relation to debt finance level. Second, the pecking order theory stipulates that a firm follows a hierarchical financing pattern: taking retained earnings first, followed by external debt and then external equity. In the context of this chapter, firms use internal financing (i.e. retained earnings) first to

Table 14.2 Summary of studies on competitive strategies in the tourism sector/industry

Source: Compiled by the authors, 2019

design their competitive strategy as this level of strategy formulation requires low financing that can be taken care of using the retained earnings of the firm. In the competitive strategy implementation level, firms require more financing to execute the strategy within turbulent tourism destinations and environments. Based on the trade-off theory and the pecking order theory, we formulate hypotheses by discussing the relationship between capital structure, competitive strategies and financial performance.

Hypotheses development

Differentiation strategy and capital structure

Since the postulation of Porter’s generic strategies, many studies have examined the financing policy impact of competitive strategics to investigate Porter’s theory and find evidence of capital structure adjustment (Barton and Gordon, 1988; Lowe et al., 1994; Jordan et al., 1998; Balakrishnan and Fox, 1993; Frangouli, 2002; Wanzenried, 2003). Using a quantitative study of UK firms, Jordan et al. (1998) did work on the link between strategy and financing policy in small and medium-sized enterprises and found that business-level strategy determines capital structure. Barton and Gordon (1988) also found a weak relationship between differentiation strategy and debt/equity mix. Wanzenried (2003) found a negative relationship between debt usage and the level of product and quantities differentiation under demand uncertainty. Meanwhile, Frangouli (2002) found a positive link between product differentiation as measured by R&D expenses to sales and debt-to-equity ratio. The author argued that internal financing strongly influences product differentiation thereby raising the industry entry barrier. Thus, product differentiation triggers a high cost of production for new entrants and a high cost of differentiation for potential new entrants. Based on this, it is hypothesized that:

Hypothesis 1: Differentiation strategy increases debt and equity usage in firms.

Cost leadership strategy and capital structure

Cost leadership describes the minimum amount of costs and assets required to achieve a high financial performance, asset use and employee productivity (Porter, 1980; Hambrick, 1983). However, Wanzenried (2003) found no support for leadership strategy and debt usage when customers’ demands are uncertain. Because firms that engage in cost leadership are likely to spend more on production capabilities and other management functions to configure an operational efficiency model, high financing is required, causing firms to exhaust internal financing and use additional external financing. We hypothesized that:

Hypothesis 2: Cost leadership strategy increases debt and equity usage in firms.

Capital structure, competitive strategies and financial performance

Firms taking generic strategies are likely to have increased financial performance following an optimal capital structure decision. A firm must consolidate its competitive strategics to keep a low level of operational costs and maintain continuous high performance. However, firms must be careful in the choice of differentiation and cost leadership strategies formulated and implemented. For example, operating costs may be both flexible and inflexible. Inflexible operating costs reduce debt payment ability and trigger bankruptcy, thereby reducing a firm’s profitability (Chen et al., 2019). Thus, firms may choose a low financial leverage ex ante when they perceived a high ex post distress cost. Consequently, since firms take advantage of unique characteristics of specialized assets, products and services to embark on differentiation strategy (Balakrishnan and Fox, 1993), they achieve increased financial performance. How firms finance operating costs and unique and differentiation strategies to increase and sustain current profitability will result in variances in capital structure. Thus, a firm’s adjustment in capital structure decision moderates the link between competitive strategies and financial performance. Matching hypotheses 1 and 2 together and examining their combined effect on financial performance, it is hypothesized that:

Hypothesis 3: Capital structure moderates the positive/negative links between differentiation strategy, cost leadership and financial performance.

Methodology

Sample

The data of this study was collected from the Datastream database for a sample period of 12 years from 2007 to 2018. The analysis of the study focused on the non-financial firms in the tourism destination of Bangladesh. The total number of firms included in this study is 85. We conduct a static panel data estimation in this study. We however excluded firms with high missing values and those registered within the last three years from 2016 to 2018.

Dependent variable - financial performance and competitive strategies

The data on financial performance (measured using return on equity, ROE) was collected from the Datastream database. We used ROE because we wanted to see how a firm’s competitive strategies affect its efficient use of the firm’s assets to increase shareholders’ wealth. The use of ROE to measure the financial performance of tourist firms is common in tourism literature (Chen, 2010; Lee and Manorungrueangrat, 2019). ROE is the ratio of net profits to outstanding shares of the firm. We use ROE over return on assets as there is no empirical model involving the link between financial performance and capital structure since ROE is sensitive to capital structure decisions (Banker et al., 2014). However, we have an equation where capital structure is a moderating variable.

Four measures of competitive strategy are employed in this study. Two competitive strategies each measure differentiation and cost leadership strategies. We use the ratio of research and development expenses to net sales (RDS) and the ratio of net sales to cost of goods sold (SCOGS) to capture differentiation strategies. We use two measures of differentiation strategies because most studies focus on RDS (such as Frangouli, 2002) and submit that it is positively linked to internal finance which supports the pecking order theory. This stand contends that firms do not only practise hierarchical financing (although it is common among small firms); large firms with high profitability do practise a trade-off theory where they take the advantage of debts. While RDS may be financed internally, SCOGS involves large investments in production, processes and distribution that would involve external financing. In relation to cost leadership, we also employed two measures. The ratio of net sales to capital expenditures on items of property, plant and equipment (SCAPEX), and the ratio of net sales to net book value of property, plant and equipment (SPPE) are used as proxies for cost leadership. Firms will achieve higher sales value if they maximize operational efficiency in the use of property, plant and equipment (Kotha and Nair, 1995; Banker et al., 2014).

Independent and moderating variable - capital structure

The moderating variable in this study came from the Datastream database. The measure of capital structure in this study includes both debt financing and equity financing. This contrasts with previous studies that used only leverage to capture capital structure (Bae et al., 2019; Chen et al., 2019). We use four measures of capital structure: debt ratio, long-term debt ratio, short-term debt ratio and equity ratio. Total debt ratio, long-term debt ratio and short-term debt ratio address the debt financing portion of a firm’s capital structure while equity ratio address the equity financing portion. Debt ratio is the proportion of total debt to total assets. Long-term debt ratio is the proportion of long-term debt to total assets. Short-term debt ratio is the ratio of short-term debt to total assets while equity ratio is the ratio of total equity to total assets. This study employed four measures of capital structure (total debt ratio, TDR; long-term debt ratio, LTDR; short-term debt ratio, STDR; and equity ratio, ER). TDR is measured as the ratio of total debt to total assets. LTDR is measured as the proportion of long-term debt to total assets. DR is measured as the ratio of short-term debt to total assets. EQR is measured as the ratio of equity to total assets. We employed equity ratio since a firm is financed with either with full debt, full equity or part debt and part equity.

Control variable - earnings per share

This study controlled for earnings per share (EPS) because firms are more likely to engage in competitive strategy as the EPS increases. It has been documented

The competitive power of capital structure 245 that earnings per share can explain the competitive information of a firm’s investment strategy (Griffin, 1976) and market-share strategy (Kama, 2009). Past studies have largely documented that earnings per share influence the profitability position (Taani, 2011; Purnamasari, 2015). This study finds earnings per share as suitable to determine competitive strategy and financial performance. EPS is measured as the ratio of net profit to number of outstanding shares.

Model specification

We estimated the impact of competitive strategies on the financial performance of non-financial firms in the tourism destination of Bangladesh. We conjecture that the impact of competitive strategies on financial performance is attributed to the heterogeneity impact of a firm’s corporate financing decisions. In moderating for the role of capital structure, this indicates that the nature of firms’ formulation and implementation of competitive strategics depends largely on firms’ access and use of debt and equity financing. The empirical model connecting competitive strategics, capital structure and financial performance is presented as follows:

The subscripts i and t represent each firm and time sampled for this study. This study examined both the cross-sectional and time effects of capital structure, competitive strategics, and financial performance. ROE is the return on equity. Cost leadership and differentiation are the two competitive strategies examined in this study. TDR is the total debt ratio. LTDR is the long-term debt ratio. STDR is the short-term debt ratio. EQR is the equity ratio and EPS is the earnings per share ratio. Error (£) is the error term. We employed a static panel data estimator to analyse the empirical models.

Empirical results

In the previous section, we formulated the empirical models of competitive strategy and profitability, taking capital structure measures as regressors and moderating variables. This section presents the results of the empirical model.

The total debt ratio has the highest mean value of 48.32%, as shown in Table 14.3. Bangladesh firms use more short-term finance than long-term finance. The average equity ratio is 18.585. ROE in comparison to debt and

Table 14.3 Descriptive statistics

Note: TDR - total debt ratio, LTDR = long-term debt ratio, STDR - short-term debt ratio, EQR = equity ratio, ROE = return on equity, EPS = earnings per share, SCOGS - ratio of net sales to cost of goods sold, RDS - ratio of research and development expenses to net sales, SCAPEX - ratio of net sales to capital expenditures on items of plant, property and equipment, SPPE = ratio of net sales to net book value of plant, property and equipment.

Table 14.4 Correlation matrix

Note: TDR = total debt ratio, LTDR = long-term debt ratio, STDR = short-term debt ratio, EQR = equity' ratio, ROE = return on equity, EPS = earnings per share, SCOGS = ratio of net sales to cost of goods sold, RDS = ratio of research and development expenses to net sales, SCAPEX = ratio of net sales to capital expenditures on items of plant, property and equipment, SPPE = ratio of net sales to net book value of plant, property and equipment.

equity finance is relatively good, at an average rate of 15.83%. All the debt finance variables are positively skewed except long-term debt, which is negatively skewed. The mean values of SCAPEX and SPPE are quite higher than the mean values of SCOGS and RDS. This is because SCAPEX and SPPE are differentiation strategics that are pursued by the firms using their items of plant, property and equipment. However, firms that pursue cost leadership strategy focus more on the cost of goods sold and expenses involving research and development. Firms try to reduce the cost of production and overheads to further pursue a cost leadership strategy.

Table 14.4 shows the correlation matrix. It shows that SCAPEX (cost leadership I) and SCOGS (differentiation strategy I) have weak positive correlation with total debt, while RDS (differentiation strategy' II) and SPPE (cost leadership II) have negative weak correlation with total debt. In relation to multicollinearity test, the findings do not reveal serious multicollinearity. Four values are well above 0.80: 0.944, 0.807, 0.829 and 0.892. The values of 0.944 and 0.807 do not belong to the same models as they’ are different strategies predicted or influenced by' capital structure decisions. The values of 0.829 (correlation between EQR and LTDR) and 0.892 (correlation between LTDR and STDR) depict slightly high values above the threshold but variables were not deleted from the model since the goal is to establish different measures of debt financing (total debt, long-term debt and short-term debt) and equity financing (EQR) in determining competitive strategies.

As shoyvn in Table 14.5, the total debt ratio and long-term debt ratio have positive effects on differentiation strategy I (SCOGS), cost leadership I (SCAPEX) and cost leadership II (SPPE). Long-term debt ratio negatively impacts differentiation strategy II (RDS), while the total debt ratio has an insignificant impact on differentiation strategy II. Long-term debt ratio has more effects on differentiation

Table 14.5 Relationship between Capital Structure and Competitive Strategy

Note: Coefficient values and t-values arc presented in die first and second lines, respectively. SCOGS = ratio of net sales to cost of goods sold, RDS = ratio of research and development expenses to net sales, SCAPEX - ratio of net sales to capital expenditures on items of plant, property and equipment, SPPE - ratio of net sales to net book value of plant, property and equipment.

The competitive power of capital structure 249 and cost leadership strategies than the total debt ratio when the coefficients of the two capital structure measures are compared. However, both short-term debt and equity ratio have negative effects on differentiation strategy I (SCOGS), cost leadership I (SCAPEX) and cost leadership II (SPPE). This finding suggests that total debt and long-term debt ratios enhance differentiation and cost leadership strategies, while short-term finance and equity finance reduce the competitive power of these strategies. Meanwhile, Bangladesh firms that focus on using R&D as a differentiation strategy can benefit more from the use of equity finance.

All the models are significant at the 1% level of significance with no serious problem of autocorrelation. The R square values show that capital structure has the most effect on cost leadership II (R² = 0.9265), more effect on differentiation strategy I (R² = 9134) and significant effect on cost leadership I (R² = 0.9006). The lowest effect of capital structure is seen when firms use R&D to pursue a differentiation strategy (R² = 0.1332). These results support the findings in Jordan et al. (1998), which found significant link between strategy and financial policy across UK firms.

Table 14.6 shows the moderating role of capital structure on the relationship between competitive strategy (SCOGS and SPPE) and financial performance. There was a significant increase in financial performance (ROE) after capital structure measures have been moderated for. In firms that consider only differentiation strategy', the moderating effect is that debt and equity finance on differentiation strategy increase financial performance while their moderating effects on cost leadership decrease financial performance. This is in line with the results of Frangouli (2002). However, in firms that pursue the two competitive strategies, long-term debt and short-term debt finance increase the effect of differentiation strategy on financial performance. Conversely, total debt and equity finance increase the effects of cost leadership on financial performance positively as against the negative effects of long-term debt and short-term debt finance on financial performance. Overall, the study finds that the moderating role of capital structure on the link between competitive strategy and financial performance varies with a combination of competitive strategies that a firm adopts.

Conclusion and policy implications

By employing the balanced panel data of 85 firms in Bangladesh, this chapter attempts to explore the heterogeneity effects of capital structure as a competitive power that can change the pattern of current competitive strategies such as differentiation and cost leadership. Generally, our empirical findings show that firms that engage in the use of high debt enhance their level of competition in the tourism industry. It implies that firms that engage more in the use of debt compete more strategically than their counterparts in a tourist destination. Furthermore, our results also show that capital structure increases cost leadership strategy while it reduces differentiation strategy. We find R square significantly increased through the competitive power of capital structure especially when debt finance is used. Theoretically, our findings support the trade-off theory over

Table 14.6 The moderating role of capital structure on the competitive strategy-finance link

Note: Coefficient values and t-values arc presented in die first and second lines, respectively. SCOGS = ratio of net sales to cost of goods sold, RDS = ratio of research and development expenses to net sales, SCAPEX - ratio of net sales to capital expenditures on items of plant, property and equipment, SPPE - ratio of net sales to net book value of plant, property and equipment.

Note: Coefficient values and t-values are presented in the first and second lines, respectively. SCOGS = ratio of net sales to cost of goods sold, RDS = ratio of research and development expenses to net sales, SCAPEX = ratio of net sales to capital expenditures on items of plant, property and equipment, SPPE = ratio of net sales to net book value of plant, property and equipment.

the pecking order theory. Firms in tourist destinations that engage more in debt finance perform better and achieve more industry leadership than firms that live on ploughed back profitability, relying on internal financing. The demands for environmental sustainability within the tourism sector require huge investments that internal finance cannot address if the firm must grow, compete and attract more investors. We found that short-term debts and equity financing negatively affect profitability while both total debt and long-term debt significantly encourage firms to participate in differentiation and cost leadership strategies.

The main corporate policy implication of the results is that debt finance, i.e. total debt and long-term debt, play a vital role in determining competitive strategies in tourist-destination environments. To ensure that firms meet with the challenges of the tourism business and continuing demands for environmental sustainability’, social innovation and corporate social responsibility, firms in a turbulent tourist environment should strive to use more debts to further enhance their competitive advantage. The use of internal financing and equity finance are not significant to enhance profitability’ and competitive strategies among firms in tourist environments. Additionally, investors in tourist environments will have less concern for agency problems as the use of additional debt will ensure the reduction of free cash flows into the hands of corporate managers.

The contributions of this study' are two-fold. Theoretically, it extended the trade-off theory of capital structure to determine the competitive strategies of firms. While past studies have documented that differentiation strategy', focus strategy and cost leadership strategy’ determine corporate competitive strategies, this study' found that the cost leadership strategy has more influence on a firm’s profitability and competitive strategy’ than the differentiation strategy. In addition, the findings of the study have practical implications to control for agency problems. The use of additional debt reduces free cash flow, implying that cost leadership helps to manage agency' problems while differentiation strategy may trigger increasing agency’ conflicts. Firms with cost leadership strategies will have high profitability which can influence their use of additional debt given the size of their profitability' and their ability' to secure creditors’ claims on the firm’s assets. Firms need additional debt to increase efficiency and productivity, improve quality' and eliminate waste. Cost leadership firms need to invest heavily’ in technology in the production process and lean production methods to control costs.

However, this study has a few limitations. The study’ focuses more on profitability as a measure of financial performance. Future studies should consider other financial and non-financial measures of a firm’s performance such a market share, customer service, customer satisfaction and employee retention. Future research should also focus on other types of competitive strategies besides differentiation and cost leadership. Areas such as Porter’s six forces model can be examined in relation to financing strategy. Industry strategics are much more important than firms’ level competitive strategies as the tourist industry faces continuous high competition and regulatory issues. Future studies should also examine the dynamic effect of capital structure on competitive strategies by using the panel generalized method of moments (GMM) estimator. By not focusing on these limitations, the findings of our study explain the practise of competitive strategies through a financing policy perspective. Financing policy hitherto best explains the heterogeneity' in firms’ competitive strategies.

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