The impact of leverage and overinvestment on project financing: evidence from South Korea

ABSTRACT

This study analyzes relationship between leverage and project financing payment guarantee using 337 firm-year observations of the listed firms on the Korean stock market from 2008 to 2017. We find that the higher the debt ratio, the greater the tendency to make risky investments as project financing payment guarantee. In addition, the relationship between the debt ratio and the project financing payment guarantee is more significant when the manager’s overinvestment tendency is greater. Despite the controversy surrounding the accounting methods of the construction companies since the introduction of K-IFRS, we report that project financing guarantees are not yet properly recognized.

KEYWORDS:

• Leverage
• overinvestment
• project financing payment guarantee

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

1. According to the previous K-GAAP, a provision should be recognized when there is a present obligation of the entity arising from past events, with very high likelihood of the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits and when the amount can be reliably estimated. A very high likelihood means that the probability of occurrence is more than 80% (K-GAAP 17 A13). However, under K-IFRS, provisions should be recognized when there is a high likelihood of future outflow (K-IFRS 1037 15). In other words, when the likelihood is more than 50%, the provision should be recognized. As mentioned above, provision recognition condition has been strengthened (with likelihood of 80% to 50%) and a significant portion of PF payment guarantee was expected to be transferred to be liability, resulting in an average increase of 20% in the debt ratio of the construction industry.

2. By marginal firms, we refer to a group of companies whose interest coverage ratio is less than 100% for three consecutive years. The interest coverage ratio is used as an indicator of the financial status of a company that can repay interest expenses through operating profit. If the compensation ratio is less than 100%, it can be regarded as a potential insolvent company.