The Business Review, Cambridge

Vol. 25 * Number 2 * December 2017

The Library of Congress, Washington, DC   *   ISSN 1553 - 5827 

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Is Time-Varying Conditional Beta A Significant Risk Measurement?

Dr. David Morelli, Kent Business School, University of Kent, Canterbury, Kent, UK



This paper finds evidence of a significant risk-return relationship on the Hong Kong stock market when beta is used as the measurement of risk.  Beta is estimated from time-varying variances and covariances estimated using variants of GARCH models.  Beta is then examined conditionally on the sign of the excess market returns.  The results show beta to be a significant risk measurement when recognition is given to the sign of the excess market return.  A strong positive risk-return relationship is found during up markets and a strong negative relationship during down markets.  When the sign of the excess market return is ignored beta is shown to be an insignificant risk measurement on the Hong Kong stock market.  Explaining what causes movements in stock prices has always been of great interest in the finance world. Over the years many pricing models have been developed both single and multifactor in an attempt to answer this.  The most well known pricing model, which is still discussed and empirically tested today, is the Capital Asset Pricing Model (CAPM) of Sharpe (1964) and Lintner (1965).  This single factor asset pricing model attempts to explain security returns through its relationship with its systematic risk.  The CAPM assumes a positive, linear risk-return relationship.  The only risk measure of any significance is systematic risk as the model assumes that idiosyncratic risk is diversified away through the holding of the market portfolio.  Despite early empirical studies supporting this positive risk-return relationship, such as those by; Lintner (1965), Black et al. (1972) and Fama and MacBeth (1973), a number of subsequent studies failed to find any such relationship.  Such studies include those of Fama and French (1992) on the US markets, Chan and Chui (1996), Fletcher (1997), Hung et al. (2004)  on the UK market, Ho et al. (2006) on the Hong Kong market, Faff (2001) on Australian market, and Elsas et al. (2003) on the German stock market. As a result of many of these studies many doubts were raised regarding the validity of the CAPM..  One of the issues with the CAPM is the problems associated with its testing.  To test the CAPM one requires the true market portfolio and also expected returns data.   With respect to the true market portfolio a proxy is used.  There are many proxies available and on the whole can be looked upon as good representations of the market portfolio, even though they do not represent the true market portfolio. However, one issue that cannot be overcome relates to the unavailability of expected data.  The CAPM is an expectation based model, namely in that it tries to explain the expected return, however all test of the CAPM are based on realized returns. The reason behind this is because expected data represents future data which clearly is not available, and the only available data is realized data which is subsequently used in testing.  With the CAPM, the expectation is that the excess market return should always be positive (the return on the market less the risk free rate), given the model assumes a positive risk return relationship and the market portfolio has risk and the risk free asset as the name implies has no risk. However all investors accept that there will be periods when the market return is less than the risk free rate, namely during down markets thus the excess market return will be negative during such periods. If this was not the case no rational investor would ever hold a risk free asset.  Given CAPM testing is undertaken using realized returns it is important that recognition is given to the sign of the excess market return when examining the risk-return relationship.  It is important to recognize that is using realized returns one cannot assume that the realised excess market return will always be positive, which would be the case if the sign of the excess market return is ignored when testing the risk-return relationship.  The application of such an assumption would be clearly be incorrect.  This is the logic underlying the methodology of Pettengill et al. (1995).  Thus this paper attempts to address the question as to whether beta is a significant risk measurement in explaining security returns on the Hong Kong stock market.  This paper examines the risk-return relationship on the Hong Kong stock market over a ten year period extending from January 2005 to December 2014.  Time-varying betas are estimated using ARCH/GARCH/ GARCH-M models.  ARCH/GARCH/GARCH-M models are used to model the conditional variance and covariances from which the time-varying betas are estimated.  Having estimated the betas the risk-return relationship is then tested both unconditionally where no recognition is given to the sign of the excess market return, and conditionally on the sign of the excess market return, and its significance as a risk factor on the Hong Kong market is determined.  The conditional CAPM, as shown by equation (1) shows the risk-return relationship conditional on information I at time t-1.    Where rpt and rMt represents the excess return on portfolio p of securities and the market portfolio respectively, and bP representing the systematic risk of portfolio of securities.   In order to model the return on portfolio p and the return on the market let’s assume that an autoregressive process can be applied and that this autoregressive process can be decomposed into their expected and unexpected components as given by equations (2) and (3) respectively.  From equations (2) and (3) the disturbance terms ept and eMt can be decomposed as given by equations (4) and (5).  From equations (4) and (5) the expectation part of the sequence, E(ept,eMt½It-1),  represents the conditional covariance between rpt and rMt and E(e2Mt½It-1)  represents the conditional variance of rMt


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Earnings and Corporate Investment

Dr. Chih-Chieh (Jason) Chiu, Rider University, Lawrenceville, NJ

Dr. Mitchell Ratner, Rider University, Lawrenceville, NJ



In this paper I examine the association of corporate investment with earnings. My findings suggest that earnings are more informative about corporate investment than are cash flows and normal accruals are more informative about corporate investment than are discretionary accruals. Further, my analysis shows that cash flows subsume discretionary accruals in explaining corporate investment.  In a world without financing frictions, corporate earnings and cash flows should explain corporate investment decisions equally well. This is because in a frictionless financial market, the information contents of the earnings and cash flows are the same. However, in a world with financing frictions, created by the separation of ownership and control, the relationship between earnings and cash flows in explaining corporate investment decisions is not so obvious.  One may argue that earnings are a lesser measure of firm performance and cannot explain corporate investments as well as can cash flows. This is because earnings are susceptible to earnings management. Earnings consist of two components: cash flows and accruals. Managers could manage earnings via cash flows or accrual manipulation. In the case of accrual manipulation, managers manage earnings upwards or downwards by changing the accrual assumptions without changing the underlying economics of the firm. The manipulated earnings hide a firm’s underlying economic conditions from its stakeholders and hence are less informative about the managerial decision making processes.  Yet one may also argue that earnings are a superior performance measure and therefore explain corporate investments better than do cash flows. According to accounting research, earnings are the premier measure of firm performances. Dechow (1994) documents that earnings are a better performance measure than cash flows because the accrual component of earnings helps mitigate the timing and matching problems with revenues and expenses.  I investigate the information content of earnings and cash flows by comparing the firm-specific investment-earnings sensitivities and investment-cash flow sensitivities. I hypothesize that earnings are more informative about corporate investments because the accrual component of earnings facilitates the matching of revenues and expenses. I also hypothesize that accrual components of earnings are more informative than cash flows about corporate investments. I further investigate whether earnings quality plays a role in relaying information to investors about corporate investments decisions. I define earnings quality by using the unsigned abnormal accruals.  I hypothesize that there are varying degrees of earnings informativeness about corporate investment among the different earnings quality groups. Specifically, I expect the earnings of the high earnings quality firms to be more informative about corporate investments.  I define discretionary accruals as the mispricing component and normal accruals as the growth component. Based on Xie’s (2001) findings, one may argue that discretionary accruals (mispricing) explain corporate investments better than can normal accruals (growth). This is because discretionary accruals are less persistent than normal accruals. Polk and Sapienza (2009) attribute the positive relationship between discretionary accruals and corporate investment to mispricing and a catering channel. One may also argue that normal accruals explain corporate investments better than can discretionary accruals. This is because normal accruals are essentially non-cash working capitals that correlate strongly with other proxies for firm growth such as long term investments. (Zhang (2007))  Even though both accrual components correlate positively with corporate investment, my findings show that normal accruals are more informative about corporate investments. The results suggest that corporate investment decisions are affected by both accrual mispricing and firm growth. However, growth is the main driver of such decisions.  In this paper, I investigate the information content of accrual components by comparing the firm-specific investment-normal accrual sensitivities and investment-discretionary accrual sensitivities by using the Vuong statistics, a non-nested likelihood ratio test. (Dechow(1994))  I further investigate the mispricing effect by studying whether cash flows are more informative than discretionary accruals in relaying information to investors about corporate investments decisions. Desai et al. (2004) suggest mispricing of accruals is encapsulated by cash flows.  My findings show that earnings are more informative than cash flows about corporate investments. Moreover, I find evidence that the accrual components of earnings are also more informative than the cash flows about corporate investments except for firms with high earnings quality. Also, I find evidence that normal accruals are more informative than discretionary accruals and cash flows about corporate investments and that cash flows are more informative than discretionary accruals. The results imply growth, and not mispricing, is the main driver of corporate investment decisions.   A large number of empirical studies find evidence of an association between cash flows and corporate investments. (1) The importance of cash flows in corporate investment decisions centers on the idea that cash flows act as collaterals that mitigate the information asymmetry and agency problems between the investors and the managers. However, average investors do not focus on cash flows as a measure of firm performance. Instead, average investors focus on reported earnings, which are regarded as the premier measure of firm performance. Under the US GAAP, corporate earnings consist of two components: cash flow from operations (CFO) and accruals (ACC). As stated in Statement of Financial Accounting Concepts, the role of accruals is to “relate revenues, expenses, gains, and losses to periods to reflect an entity’s performance during a period instead of merely listing its cash receipts and outlays”. This leads to my first hypothesis:  H1. Earnings are more informative about the corporate investment decisions than cash flows.  Next, I investigate whether the accrual component of earnings is more informative about corporate investment decisions than the cash flow component of earnings. Specifically, I hypothesize that earnings are more informative because the accrual component of earnings mitigates the cash flow timing issue by matching the revenues with expenses. This leads to my second hypothesis:  H2. Accruals are more informative about the corporate investment decisions than cash flows.  Prior accounting research document that accruals are less persistent than cash flows and are susceptible to manipulation. Managers manage earnings upwards or downwards by changing the accrual assumptions without changing the underlying economics of the firm. The manipulated accruals hide a firm’s underlying economic conditions from its stakeholders and cause investors to misprice the value of the firm. Specifically, Xie (2001) shows investors misprice the discretionary accrual component of accruals, which leads to lower future returns.  On the other hand, research also shows that accruals correlate strongly with other growth proxies such as book-to-market ratio and fixed assets, which suggests that accruals contain important information regarding corporate investment decisions.  I split the accruals into the normal accruals (growth component) and the discretionary accruals (mispricing component). I hypothesize that there are varying degrees of informativeness about corporate investment among the different accrual components.


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A Comparison of the Service Quality of Operate-Transfer Swimming Pools

Dr. Cheng-Ping Li, Minghsin University of Science and Technology, Taiwan R.O.C.



The main purpose of this study is to compare the different types of service quality regarding the outsourcing of swimming pools in Taipei City. With the questionnaire methodology, 451 users of two swimming pools are recruited as participants. The data is analyzed by descriptive statistics, t-testing, and one-way ANOVA to test the assumptions. The main findings are as follows:  Most of the subjects of this study are males; distribution of all ages is average; most education backgrounds are college and above. Subjects share the highest agreement in “assurance” and “tangibility” of outsourced swimming pools in this study.  Significant differences exist in age, education background, and monthly income of subjects. People aged over 41 have higher agreement in the five dimensions of service quality than subjects aged between 31 and 40 and under 30. Regarding education background, the factors of subjects holding master’s degrees or above are obviously higher than those holding bachelor’s degrees or vocational school diplomas. Regarding “tangibility”, “reliability”, and “empathy”, subjects holding master’s degrees or above are higher than those holding high school diplomas. Finally, subjects with monthly income of over 50,001 NTD have higher agreement in “reliability”, “responsiveness”, “assurance”, and “empathy” Regarding the differences of service quality of outsourced swimming pools of different modes, government-outsourced swimming pools have higher service quality than school-outsourced swimming pools in “tangibility” and “empathy”.  In recent years, the government has built swimming pools, swimming facilities, and sports center in schools of all levels, and privately operated swimming pools have gradually increased (Hsu, 2002). However, due to a lack of human resources and funding, as well as increased external competition, school-built swimming pools face difficulties in operation. Therefore, government-built swimming pools are mostly outsourced to relieve economic burden (Wang, 2001). Under the circumstances of poor government finance and a lack of school funds, the government encourages individuals to participate in outsourcing the businesses of BOT (Building-Operate-Transfer) and OT (Operate and Transfer) swimming pools, thus, outsourced swimming pools will be the trend in the future (Liu, 2005).  At present, the business mode of OT (operate transfer) is the most common form, meaning that after being invested and constructed by the government, swimming pools are outsourced to non-government institutions. When the operation is terminated, the right of management is given back to the government, as the operatorso btain the right of management through bidding. Taipei first established the Zhong-Shan Sports center on March 1, 2002. Under the guidance of the strategy of government-built-and-private-operation, services, and free activities, many Taipei citizens areattracted to the center (Lin, 2005).  Withthe rapid development of urban construction, spaces for the public to enjoy activities is reduced. In order to solve this problem, indoor sport stadiums are established to allow the public to fully enjoy sports without being limited by the weather (Huang, 2006). However, this causes private business operators to compete with each other. Under competitive pressure, the conditions of swimming facilities will directly influence its business. How outsourced operators face these challenges is the first motivation of this study.  While the purpose of government outsourcing is to save operating expense, allowing operators take responsibility for operations and management will cause many problems. When probing into the situation of swimming pools in Taiwan, Wu (2011) pointed out the problems of swimming pool promotion,includingpoor pool facilities and health qualities, poor pool maintenance and management, poor maintenance of environment, and poor water quality and temperature. Chen (2005) explored outsourcing construction and attracting investment in national vocational schools, and observed that complete swimming pool facilities and outstanding market conditions are the key factors for successful outsourcing. Participation in the sport industry is a part of the sport service industry (Lu, 2012). One of the necessary factors of a sustainable leisure sport industry is to provide good products and service quality (Kao, 1994). Kao also believed that “service quality is a key factor in the operation and management of the sport service industry”. Through high-quality service, operators can improve customer’s satisfaction, increase their intent to purchase, and differentiate themselves from other companies. While tangible products are easy to copy, intangible services cannot be copied, thus, intangible assets are the core advantage of enterprises. Swimming pools belong to the sport service industry, and in addition to hardware, complete management and a staff service system should be established (Farmer & Mulrooney, 1993). Therefore, how service quality is provided by outsourced swimming pools is the second motivation of this study.  Chang (2007) argued that, the OT mode of outsourcing the business of school swimming pools mainly face the issue of old pool design. Lin (2010) explored the difficulty of privately operated swimming pools in Taipei’s municipal elementary schools, and pointed out that the swimming pools face competition from private swimming pools and sports centers. Particularly, during the operations of sports centers, how can they make customers feel the difference of the provided service quality? Therefore, swimming pool operators should be aware of the concept of consumer-orientation, focus on the characteristics of present and potential customers, and know their expectations and needs for swimming pools, in order to improve their service quality and meet customer’s needs (You, 2002).  This study takes Taipei City as the case to explore customer’s expectations and needs through comparisons between the swimming pools of sports centers and outsourced schools. This study also provides the information as reference for relevant industries to improve service quality. Studies on the service quality of swimming pools and sports centers have attracted attention in recent years. Studies on service quality mainly adopted the SERVQUAL scale. As shown, if a swimming pool intends to be competitive, make profits, and expand, they must provide good service and satisfy customers. Therefore, differences in service quality are key factors, as service quality reflects customer’s behavior, operational strategies, management, plans, and assessments.  This study can provide reference for the operation and development of swimming pools. According to the research background and motivation, this study aims to probe into service quality, and learns customer’s cognition regarding the service quality of outsourced swimming pools. This study takes an outsourced swimming pool in Wanhua District, Taipei City as an example to explore the differences of service quality provided by outsourced swimming pools. The specific purposes of this study are, as follows:  To learn the situation of demographic statistics of swimming pool consumers.  To learn the situation of service quality of an outsourced swimming pool.  To explore the difference of the variance of consumers regarding service quality.  To compare the differences of the service quality of outsourced swimming pools of different modes.  This study is conducted during March and April, 2016, and questionnaires are used to explore the differences in the service quality of outsourced swimming pools of different modes and the swimming pools of sports centers outsourced by Taipei government. The customers of swimming pools are the subjects, and random sampling is adopted to conduct the questionnaire survey; the sampling error is less than 5% and confidence interval is 95%. Required samples amounted to 385 pieces. In order to avoid invalid questionnaires leading to insufficient samples, 250 questionnaires are distributed, respectively, at two swimming pools. This study conducts a questionnaire survey from March 1 to March 30, 2016, uses random sampling, and collects 451 valid questionnaires and 49 invalid questionnaires, for a valid recovery rate of 90.2%.    This study adopts the SERVQUAL scale (Parasuraman et al., 1988), as widely applied in different service industries, to assess service quality. This scale is revised by the author, and is proved to have good validity. Taiwanese scholars (Wu, 2003; Chen, 1996) localized the scale to be a measurement tool of service quality, and the study results reflect similar validity, thus, this study applies this scale as the research tool. According to the classification of the original author, the measurement dimensions of satisfaction with service quality are divided into “tangibility”, “reliability”, “responsiveness”, “assurance”, and “empathy”. The questionnaire adopts a Likert 5-point scale, and scores are added according to each term, with 22 in total.


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The Difference between Consumer Needs and Wants: Based on the Store Proximity between Haagen-Dazs and Starbucks

Dongxiao Wang, East China Normal University, Shanghai, China

Dr. Hung-hsin Chen, East China Normal University, Shanghai, China



The purpose of this paper is to investigate the differences between customer needs and wants of Starbucks and Haagen-Dazs to take the real needs of consumers as a starting point, and discuss the feasibility of the methods and ways to short the gaps between the actual needs or wants of the customers and the stores’ behavior in the end. After the survey from 4 stores of Starbucks and 4 stores of Haagen-Dazs in Shanghai, we found the differences between customer needs and wants of Starbucks and Haagen-Dazs. This paper suggests that it can make most customers enjoy more with the needs of their own services, and improve the competitiveness of these brands. This study draws on the consumed perspective to investigate consumer real needs and wants with the differences in contrasting stores.  Since Starbucks entered China in 1998, in less than two decades, it has so far received higher profits in China than in Europe. Comfortable seats, beautiful music, quiet space, with a cup of Starbucks coffee, all this things captured hearts and minds of many white-collar workers. While early in 1996, Haagen-Dazs had come to mainland China firstly. With its high quality and the perfect Declaration of love, it gradually occupied the high-end market, and achieved high performance. The dominant flavor of Haagen-Dazs is sweet and memorable, "Love her, take her to eat Haagen-Dazs," is a lot of customers ' first impression of Haagen-Dazs.  However, insiders of Haagen-Dazs has talked about such a phenomenon that, where there is a Starbucks, the income of Haagen-Dazs is not so satisfactory. Not to mention the benefit of a shop is determined by many factors. The main products of Haagen-Dazs are ice cream, while Starbucks' main products are coffee. So both of them seems to be associated difficultly. However, consumer needs sometimes is not an ice cream or a cup of coffee. So, what are the real consumer needs of Starbucks and Haagen-Dazs? What are consumer wants of them? The inquiry of the difference between customer needs and wants in these two stores, is a continuous process of exploring real customer needs and wants of them. In some cases, the consumer needs are an ice cream or a cup of coffee; but in other cases, probably most cases, consumer needs or wants may not look so simple apparently.  In the market, the appearance of products is the results of the driving force to meet some customer needs or wants. The target of customers, or customer's needs or expectations, all could be called consumer needs. That is to say, in some cases, to solve some problems of customers is the customer's needs. While for different products, there may be different needs. From the above, we know that different consumers have a variety of needs. In this survey, the extent of solving consumer needs for different customers to the same product are not the same. Therefore, there is individual differences for consumer needs. Since consumers' personal tastes and preferences are often different, their information needs are different too. If businesses provide the same information to all consumers, the information may be too general, and may not be able to meet any specific customer needs. Hence personalized information is needed. Although information personalization process may take more time and cost, it will benefit every consumer (Beales, Mazis et al. 1981). Consumer needs is an important and decisive factor in consumers’ purchase decision making. Of course, it does not mean that choosing to buy it must meet some of consumers unsatisfied needs. However, when a product or service solves some unmet needs of customers or certain problems, customers will have greater possibilities to purchase such products or service (Tauber 1973).  In fact, for the customer's wants, it not only contains the needs, but exceeds the needs. Wants is a need added some residual, and not meeting the requirements of the concept. It is the motivation, wishes and requirements for customers to buy goods or services, and the necessary conditions that turning the potential purchasing power into real purchasing power of customers. Do not sell what you're going to produce, but what consumers want (Fennell 1978). Consumer needs belong to the desire that the majority of people who meet the needs mostly could afford. (Raiklin and Uyar 1996).  Customer wants differed by different individuals, but had similar properties. The degree of customer wants may also be innovative, but it may not be precisely known that what was the degree or how to achieve it (Tosdal 1936). The wants control and totally dominate our thoughts, feelings, and actions. It needs to be caught, or aroused. Potential consumers who have passion consume by virtue of wants (Russell W.Belk 2000). The best way to assess the customer's wants is the market (Hicks 1962).  Meeting customer needs and wants is the basis for any marketing (Chung 2011). Of course, it is really different between needs and wants (Raiklin and Uyar 1996); for the customer's choices, they play a particularly meaningful role; their differences and nuances will decide marketing strategy (Mahatoo 1989). ‘Needs’ and ‘wants’ is personal consumption, which is the ultimate goal of all production and distribution on the capitalist economic system. Needs and wants meet their individual pursuits through the goods and services. Wants itself have two sources: one is biological, and the other is social cultural. Both have the same origin, so if one of them disappeared, the other would cease to exist (Raiklin and Uyar 1996). The needs of customers includes their physical needs which is in Maslow's theory, low levels of demand (Raiklin and Uyar 1996); customer wants, such as the social wants of customers, demand vanity, love demand, is in Maslow hierarchy of needs, higher levels of needs, including the want for self-realization, social wants and esteem wants.  "If out of the office, I will be in Starbucks; if not in Starbucks, I am certainly on the way to Starbucks," people would think of this when it comes to Starbucks. Why do customers like going to Starbucks so much? Just because Starbucks coffee or not? Customer needs for Starbucks, sometimes may be a cup of fragrant taste coffee. It depends on the environmental conditions, customers ' personal preferences or others. The wise consumers orientation of Starbucks also reflects consumer needs whose pursuit is the quality coffee (Zheng 2009). Customer needs, of course, include the needs of physical and security. Physiological needs are such as breathing, sleeping, homeostasis, water, food, secretion and resistance. More simply, customer physiological needs for Starbucks may include: 1. A thirst-quenching taste of coffee or other drinks; 2. Foods such as desserts; 3. The use of coffee to turn off sleepy; 4. The customer's body needed a break after a little tired; 5. Sleep; 6. Go to the restroom. Under the current social security conditions, the safety requirements are in default met in this paper.  Physiological needs are the needs everyone has. From the perspective of physical need, all consumers can be or are expected to become the consumers of Starbucks. However, what Starbucks sells is not just coffee, as well as experiences. Customer wants, vary from individuals who have different preferences. Such as: 1. Sensory experience wants, including gourmet coffee, shop style, color and other characteristics of the environment bringing sight, smell, hearing, touch, taste experience. When customers walk into Starbucks, "Starbucks taste" is blowing at that moment. The smell of coffee, dim but warm lighting, carefully chosen ornaments on display and lamps, coffee hiss, aromatic and delicious coffee, are everywhere. 2. Starbucks is not just coffee, but also a boundless emotional experience wants (Dong 2005). It includes gathering relatives and friends mentioned before; the warm quiet time for loving people, which makes time stagnant; personal enjoyment, with convenient conditions providing for customers such as Wi-Fi or other facilities. 3. Consideration experience wants. It creates a thinking atmosphere full of a sense of wonder, and inspires consumers to discuss events, such as the elegant manners of customers, different languages music in stores. 4. Action experience wants, includes rich body experience and interactive between staffs. Starbucks had timely put forward the concept of "the third space" which polymerized diverse needs energy, and promoted it to the position like their own family or work place. The creation of the third space made consumers gradually aware of it, accept and start using it. What’s more, it produced a new practical value and inner experience (Hongbin 2006). Social experience wants, include community and social identify, cultural values, social impacts and social roles. 5. Accessing to such occasions shows the identity and status of the customer; 6. Consumers think that the consistent brand image is fit with self-concept for Starbucks, and believe they can change their identification because of the purchase of the brand products. Community makes a higher level of consumer wants met (Wen 2010); 7. Starbucks cups, coasters, bags of coffee beans with exquisite packaging, music, fashion magazines and newspapers, all these facilities make drinking a cup of coffee a life experience. These will make consumers impressed Starbucks is full of cultural atmosphere; 8. Compared to other noisy eating place, Starbucks can improve their quality and differentiate themselves. So buying Starbucks coffee could be proud of (Wei 2008).


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The Effect of Taxes on Corporate Financing Decisions: Evidence from Brazilian and American Firms

Peter V. Fonseca, Mackenzie Presbyterian University, Brazil

Dr. Michele N. Juca, Mackenzie Presbyterian University, Brazil



According to trade-off theory, encouraged by debt tax benefit, the company uses third-party capital to the level at which the costs, associated with bankruptcy risks, outweigh this advantage. The United States represents the largest economy in the world and Brazil is a developing country, with one of the highest tax burdens in the world. This paper analyzes whether the tax benefit has a positive effect on the capital structure of American and Brazilian companies. The sample comprises 407 American1 and 217 Brazilian2 non-financial or utility companies, whose data are obtained between the period of 2008 and 2015. By means of three tax variables - kink, standardized kink and tax payment - dynamic adjustment models of capital structure are estimated. The results confirm that tax benefit influences the capital structure decisions of Brazilian and American companies. In addition, Brazilian and American companies are identified as having a conservative position in terms of indebtedness.  After their seminal paper of 1958, Modigliani and Miller (1963) recognize the existence of the effect of tax benefit on debts. According to them, this tax shield on debt increases the company´s value, since it reduces its cost of capital. It means that there is an optimal capital structure allowing the maximization of shareholders´ wealth, which confirms the traditional theory by Durand (1952). Empirically, companies tend to behave as if there is an optimal capital structure.  According to Weston and Brigham (2000), the target structure of capital involves the exchange between risk and return. High risk, associated with high debt, tends to reduce the stock price. However, higher expected rate of return raises that price. Thus, the company's goal is to find the optimal capital structure, in which the marginal tax benefits of debt are equal to its marginal costs. Furthermore, considering the high tax rates that companies face, the influence of tax shield on the capital structure of firms is potentially significant.  Moreover, since there are considerable differences between Brazilian and American tax policies, this paper aims at comparing the effect of debt tax benefits on the capital structure of public firms in both countries. Based on trade-off theory (TOT), the main hypothesis of this study is whether there is a positive relationship between the level of indebtedness and the tax benefit (H1). To test this, two samples of non-financial or utility companies - 407 American1 and 217 Brazilian2 – are analyzed by means of a regression with dynamic panel data - Equation 4.  The annual data are obtained from Standard and Poor´s (S&P) IQ Capital database between 2008 and 2015. Another differential of this study is that, the analysis of the influence of taxes on corporate capital structure is made through more appropriate proxies, such as kink and standardized kink. As a result, the hypothesis is in fact confirmed. This means that the tax benefit arising from debt affects the companies´ capital structure.  Additionally, on the one hand, Brazilian companies are verified as adopting a conservative use of their debts, to capture the benefits of tax deduction. On the other hand, US companies have a more prolonged process of capital structure adjustment than Brazilian companies.  According to Durand (1952), an optimal combination of third-party capital and equity can be obtained and should be sought by the companies as a means of maximizing their market value; this is referred to as traditional theory. Modigliani and Miller (1963) acknowledge that, the higher the indebtedness level, the greater the savings with taxes and, therefore, the greater the company´s value.   Other factors as highlighted herein, are stated as affecting companies´ capital structure, thus establishing new relationships: trade-off theory (TOT), pecking order theory (POT), information asymmetry and bankruptcy costs, which give rise to the hypotheses of this work. For Miller (1977) and Myers (1984), TOT shows the existence of an optimal level of indebtedness reached by companies as a result of the balance between tax benefits and debt costs. This way, tax benefits encourage the use of third-party capital (H1), and debt costs result from the probability that a company will default, in face of the problems related to higher indebtedness.  In contrast, Myers & Majluf (1984) argue that, because profitable firms generate more cash than less profitable firms do, the expectation under POT theory is that profitable firms have less debt in their capital structure (H2). Thus, firms with lower growth potential should not hold debt, assuming that internally generated resources are sufficient to finance existing growth opportunities (H4). From the perspective of the information asymmetry theory, capital structure decisions are made in the context of imbalance between the information held by the company and those held by the investors (Akerlof, 1970).  In turn, according to Frank & Goyal (2009), the availability of collateral is one of the most reliable factors considered in capital structure decisions among American companies. Thus, from the viewpoint of the theory of bankruptcy costs, companies with more collateral tend to be more leveraged (H3). Furthermore, Altman (1968) develops a forecast model, known as Z-Score, to assess the probability of corporate bankruptcy. Bartholdy and Mateus (2011) find a negative correlation between Altman´s Z-Score (ZA) and the levels of indebtedness. According to the aforementioned authors, if bankruptcy is expensive, then, the amount of debt should be a decreasing function of the probability of bankruptcy (H5)  Finally, there are tax policy differences between Brazil and the United States of America (USA). In Brazil, for instance, there are three types of tax regimes most used by companies: real profit, presumed profit, and the simplified taxation system, known as Simples Nacional. Real profit is the regime that allows the deductibility of interest on indebtedness - tax benefit - whose general rate is 34% (Santos & Oliveira, 2008).   Yet, the USA has the highest corporate income tax rate, set at 35% at the federal level, and the average tax on corporate income at the state and local levels amounts to an additional 4%, which brings the total tax rate to 39% (Brownlee, 2016). Under the US tax system, interest on third party capital is also deductible in the calculation of corporate tax.  The main hypothesis of this work – (i.e., there is a positive relationship between debt tax benefit and corporate indebtedness) - is verified by means of a regression model, with unbalanced dynamic panel data; - see Equation 4. The final sample consists of non-financial or utility companies - 407 American1 and 217 Brazilian2 - comprising 3,256 and 1,736 observations between 2008 and 2015, respectively. The data are obtained from the S&P´s IQ Capital database and analyzed using Stata econometric software, - version 13. The proxies associated with debt tax benefit - independent variables - are kink, standardized kink and tax payment.   The kink variable is defined as the ratio of earnings before interest and taxes, that is, the amount of interest required to make the earnings equal to zero. If kink is less than 1, the pre-tax profit (Ebit) is less than the interest actually paid. In this case, the profit after interest (EBT) is negative. This represents an aggressive debt policy. In this case, there is no need of surplus interest. However, if kink is greater than 1, the profit after interest (EBT) is positive, and the company uses debt more conservatively. In other words, the company can raise more debt. Finally, when kink is equal to 1, the company optimizes its indebtedness capacity, obtaining the maximum of tax benefit, as shown in Figure 1. According to Graham (2000), the kink variable is a result of the ratio between Earnings Before Interest and Taxes (Ebit) - and the interest paid on debts – Equation 1.


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