The Determinants of Capital Structure Choice Finance Essay

Study of Rajan & Luigi, 1995, investigates the determinants of capital structure choice by analyzing the financing decisions of public firms in the major industrialized countries. At an aggregate level, firm leverage is fairly similar across the G-7 countries. They find that factors identified by previous studies as correlated in the cross-section with firm leverage in the United States, are similarly correlated in other countries as well. However, a deeper examination of the U.S. and foreign evidence suggests that the theoretical underpinnings of the observed correlations are still largely unresolved. A recently compiled database of inter- national corporations, Global Vantage, helps us, at least partially, address this problem.

They limit their attention to the largest economies where there are sufficient firms represented to make comparisons meaningful. In particular, they focus on non-financial corporations of the G-7 countries. In 1991, Global Vantage covers more than two thirds of the companies (representing more than 90 percent of the market capitalization) in countries with a small stock market (France, Germany, and Italy). In the other major countries Global Vantage covers between one third and one half of the companies traded, representing more than 75 percent of the market capitalization. They eliminate financial firms such as banks and insurance companies from the sample because their leverage is strongly influenced by explicit (or implicit) investor insurance schemes such as deposit insurance. They find that, at an aggregate level, firm leverage is more similar across the G-7 countries than previously thought, and the differences that exist are not easily explained by institutional differences previously thought important. The factors identified by previous cross-sectional studies in the United States to be related to leverage seem similarly related in other countries as well. However, a deeper examination of the United States and foreign evidence suggests that the theoretical underpinnings of the observed correlations are still largely unresolved. Study of Titman & Roberto, 1988, analyzes the explanatory power of some of the recent theories of optimal capital structure.

The study extends empirical work on capital structure theory in three ways. First, it examines a much broader set of capital structure theories, many of which have not previously been analyzed empirically.

Second, since the theories have different empirical implications in regard to different types of debt instruments, the authors analyze measures of short-term, long-term, and convertible debt rather than an aggregate measure of total debt. Third, the study uses a factor-analytic technique that mitigates the measurement problems encountered when working with proxy variables. We present a brief discussion of the attributes that different theories of capital structure suggest may affect the firm’s debt-equity choice. These attributes are denoted asset structure, non-debt tax shields, growth, uniqueness, industry classification, size, earnings volatility, and profitability. The attributes, their relation to the optimal capital structure choice, and their ob- servable indicators are discussed.

The variables discussed were analyzed over the 1974 through 1982 time period. The source of all the data except for the quit rates is the Annual Compustat Industrial Files. The quit-rate data are from the U.S. Department of Labor, Bureau of Labor Statistics, “Employment and Earnings” publication. These data are available only at the four-digit (SIC code) industry level for manufacturing firms. From the total sample, we deleted all the observations that did not have a complete record on the variables included in our analysis.

Furthermore, since many of the indicator variables are scaled by total assets or average operating income, we were forced to delete a small number of observations that included negative values for one of these variables. These requirements may bias our sample toward relatively large firms. In total, 469 firms were available. They find that debt levels are negatively related to the “uniqueness” of a firm’s line of business. Transaction costs may be an important determinant of capital structure choice.

Short-term debt ratios were shown to be negatively related to firm size, possibly reflecting the relatively high transaction costs small firms face when issuing long-term financial instruments. Additional evidence relating to the importance of transaction costs is provided by the negative relation between measures of past profitability and current debt levels scaled by the market value of equity. Results do not provide support for an effect on debt ratios arising from non-debt tax shields, volatility, collateral value, or future growth. However, it remains an open question whether our measurement model does indeed capture the relevant aspects of the attributes suggested by these theories. Study of Gupta, 1969, is a modest contribution to the theory of financial structure. It seeks to analyze the financial ratios with three exogenous variables-industry, size and growth. The scope of this study is limited to a cross sectional analysis for the year 1961 to 1962. The study is based on data published in statistics of income by internal revenue service for that year.

One hundred seventy three manufacturing corporations, covering 21 standard industrial classification two digit industries, classified into 13 size categories, were examined. The firm size categories ranged from total assets of less than 50 thousand dollars to assets of 250 million and more.

Four broad categories of ratios- profitability, turnover, and leverage and liquidity ratios were examined. A positive association was observed, however, between TD/TA and Fixed asset turnover. With the respect to liquidity, the evidence indicates that industries which have low investment in current asset per dollar of sales tend to have a low current ratio. The productivity of assets varies widely from one manufacturing industry to another. Industry with formidable barriers to entry and an oligopolistic market structure tend to have a very high productivity of assets. It is also high in industries which are research and development oriented. So for as the growth of the corporations is concerned a clear pattern emerges of high total asset turnover, high fixed asset turnover, and high current asset turnover associated with high growth rate of company.

They have also high inventory turnover, higher cash velocity and lower average collection period. The current liability turnover is found to be negatively associated with corporate growth. When growth is related to productivity of assets, however, no significant relationship is observed. A very significant negative partial correlation coefficient is observed between fixed asset turnover and size of corporation. Study of Bancel and Usha, 2004, analyze that the surveys managers in 16 European countries on the determinants of capital structure. Financial flexibility and earnings per share dilution are primary concerns of managers in issuing debt and common stock, respectively. We find that firms’ financing policies are influenced by both their institutional environment and their international operations. Firms determine their optimal capital structures by trading off costs and benefits of financing.

They also examine the role of legal institutions in explaining the financing policies of firms across countries. They investigate whether these policies are determined largely by the legal institutions of the home country or are the result of a complex interaction of several institutions in a country. They also study the sensitivity of different determinants of capital structure to the country’s institutional environment. Second, the quality of the country’s legal system explains cross-country variations in the rankings of several major factors, but so do other country-specific factors such as cost of capital. In addition, although differences in debt policy factors vary systematically with the quality of a country’s legal system, firm-specific factors such as the firm’s growth opportunities strongly influence the common stock policy factors.

Overall, our results support that most firms determine their optimal capital structure by trading off factors such as tax advantage of debt, bankruptcy costs, agency costs, and accessibility to external financing. Study of Roden and Wilbur, 1995, analyze the composition of the financing packages used in a large sample of leveraged buyout transactions in order to test a set of hypotheses developed in the prior literature about the determinants of corporate capital structure decisions. They focus in particular on the role of agency costs, bankruptcy risks, and tax considerations. They find evidence that all three have an impact, both on the degree of leverage employed in the transactions and on the attributes of the borrowings undertaken. The impacts are manifest in systematic co relationships between the proportion and type of debt in the buy out financing package and the target firm’s earnings rate, earnings variability, growth prospects, and its tax and liquidity position. Study of Harris & Artur, 1990, provides a theory of capital structure based on the effect of debt on investors’ information about the firm and on their ability to oversee management. They postulate that managers are reluctant to relinquish control and unwilling to provide information that could result in such an outcome.

Debt is a disciplining device because default allows creditors the option to force the firm into liquidation and generates information useful to investors. They characterize the time path of the debt level and obtain comparative statics results on the debt level, bond yield, probability of default, probability of reorganization, etc.

They develop both static and dynamic models. In the static model, they consider a once-and-for-all choice of debt level. In the dynamic model, we examine the evolution of capital structure and net payments to debt holders over time. They address the implications of our model for capital structure as well as such issues as what determines liquidation vs. reorganization, how capital structure changes after reorganization, the probability of liquidation given default, and the relationship between debt level and the probability of default. They also examine the effects of changes in capital structure on stock prices and provide comparative statics results on the debt level, market value of debt, firm value, bond yield, probability of default, probability of reorganization given default, and other variables of interest. In particular, we show how these variables respond to changes in firm size, liquidation value, and default costs. Thus, they obtain a theory of capital structure, debt repayment schedules, and reorganization.

Results for the static model include the debt level, market value of debt, firm value, debt-to-value ratio, and promised bond yield all increase with increases in liquidation value and decrease with increases in default costs; the probability of default increases with liquidation value, decreases with default costs, but is independent of firm size; the expected debt coverage ratio3 decreases with liquidation value, increases with default costs, but is independent of firm size; the probability of reorganization given default decreases with liquidation value and is independent of default costs; leverage-increasing changes in capital structure that are caused by increases in liquidation value, decreases in default costs, or both are accompanied by increases in firm value; more highly levered firms will also offer larger promised yields, have lower debt coverage ratios, and have lower probability of reorganization after default. Using the dynamic model,They show that debt levels relative to expected income and default probabilities are constant over time, except when “endgame” considerations are important; expected debt coverage ratios increase and default probabilities decrease following reorganization. Study of Hovakimian & et.al, 2001, shows that when firms adjust their capital structures, they tend to move toward a target debt ratio that is consistent with theories based on tradeoffs between the costs and benefits of debt. In contrast to previous empirical work, our tests explicitly account for the fact that firms may face impediments to movements toward their target ratio, and that the target ratio may change over time as the firm’s profitability and stock price change. A separate analysis of the size of the issue and repurchase transactions suggests that the deviation between the actual and the target ratios plays a more important role in the repurchase decision than in the issuance decision. We use firm level data from the 1997 Standard and Poor’s Compustat annual files (including the Research file). We require firms to have financial statement and stock price information in the issue year and in the two preceding years. Firms in the financial sector are not included in the sample because their capital structures are likely to be significantly different from the other industrial, natural resources, and services firms in our sample. In total, they have 39,387 firm years covering the 1979-1997 periods. In the first stage, the debt/assets (leverage) ratio, Lev, is regressed on a vector of explanatory variables, W, that have been used in past cross-sectional studies of capital structure. Debt/assets is defined as the book value of debt divided by the sum of the book value of debt and the market value of equity.6 The purpose of this first stage regression is to provide an estimate of each firm’s optimal or target leverage ratio, which they define as the debt ratio that firms would choose in the absence of information asymmetries, transaction costs, or other adjustment costs. Our results suggest that although past profits are an important predictor of observed debt ratios, firms often make financing and repurchase decisions that offset these earnings-driven changes in their capital structures.

Specifically, when firms either raise or retire significant amounts of new capital, their choices move them toward the target capital structures suggested by the static tradeoff models, often more than off setting the effects of accumulated profits and losses. This qualitative pattern persists regardless of the maturity or the convertibility of the debt being issued. Our results also suggest that stock prices play an important role in determining a firm’s financing choice. Firms that experience large stock price in? Creases are more likely to issue equity and retire debt than are firms that experience stock price declines.

This observation is consistent with the idea that stock price increases are generally associated with improved growth opportunities, which would lower a firm’s optimal debt ratio. The negative relation between past stock returns and leverage increasing choices is also consistent with agency models where managers have incentives to increase leverage when stock prices are low. These results are also consistent with the idea that managers are reluctant to issue equity when they view their stock as being under priced. Study of Ferri & Wesley, 1979, to investigate the relationships between a firm’s financial structure and its industrial class, size, variability of income, and operating leverage. The methodology used in this paper is new to this area of inquiry and promises superior results, because it avoids several measurement difficulties encountered in previous work. The resolution of these difficulties occurs through the development, within this paper, of a taxonomy of firms that is based on the firms’ actual financial behavior.

The taxonomical structure will provide the basis for an examination of associations between financial structure and industrial class, size, variability of income, and operating leverage.The data used in the present investigation were gathered from the Compustat data tapes which contain the year-end balance sheet and income statement for industrial, domestically headquartered, unregulated firms. The total sample of firms selected (for consistency of fiscal year and availability of data) amounted to 233 firms.

The distribution of selected firms by Standard Industrial Classification Code (SIC Code) and by generic industry groupings is given in the appendix. Data on the sample firms was gathered for two five year time spans: from 1969 to 1974 and from 1971 to 1976. Multi-period variables (average sales, coefficient of variation in operating income, etc.) are calculated on the basis of data from each year in the five year spans. Single period variables (debt to total assets, current sales, etc.) are computed on the basis of data from the terminal year in the two time spans. The leverage classes were derived by use of the Howard-Harris clustering algorithm, which created taxonomy of firms based on measures of their financial structure.

Formally, this algorithm partitions a set of objects, where each object is characterized by a multivariate. Each of the resulting leverage groups derived in the present application of the algorithm is as distinct as computationally possible. The results of the study’s effort to relate firm characteristics to leverage class can be summarized in this way: a) industry class is linked to a firm’s leverage, but in a less pronounced and direct manner than has been previously suggested; b) a firm’s use of debt is related to its size, but the relationship does not conform to the positive, linear scheme that has been indicated in other work; c) variation in income, measured in several ways, could not be shown to be associated with a firm’s leverage; and d) operating leverage does influence the percentage of debt in a firm’s financial structure and the relationship between these two types of leverage is quite similar to the negative, linear form which financial theory would suggest. Study of Sibilkov, 2007, tests alternative theories about the effect of asset liquidity on capital structure. Using data from a broad sample of U.S. public companies, I find that leverage is positively related to asset liquidity. Further analysis reveals that the relation between asset liquidity and secured debt is positive, whereas the relation between asset liquidity and unsecured debt is curvilinear.

The results are consistent with the view that the costs of financial distress and inefficient liquidation are economically important and that they affect capital structure decisions. In addition, the results are consistent with the hypothesis that the costs of managerial discretion increase with asset liquidity. The liquidity index is positively associated with leverage, and prior changes in the liquidity index are positively associated with subsequent changes in leverage. The findings are consistent with the hypotheses that is, asset liquidity increases optimal leverage. The costs of illiquidity and inefficient liquidation are economically significant and substantial compared with the benefits of debt, and managers attempt to control these costs by adjusting leverage and the probability of incurring liquidation costs. I also find that the relation between the liquidity index and the level of secured debt is positive, and that between the liquidity index and unsecured debt is curvilinear.

These findings are consistent that is, the effect of asset liquidity on debt depends on whether managers have disposition over those assets. Asset liquidity has a positive effect on firm debt when managers cannot dispose of firm assets and a curvilinear effect on firm debt when they can. The findings further suggest that asset liquidity increases the costs of managerial discretion because higher asset liquidity makes it less costly for managers to sell assets and divert value from bondholders. Restrictions on asset disposition effectively reduce the liquidity costs of managerial discretion, and managers do not divert value by liquidating assets when their liquidity is low, because the private benefits of managing those assets outweigh the gains from the costly asset transformation. Thus, the private benefits of control act as a deterrent to asset liquidation and value expropriation by managers, alleviating agency problems.

Overall, the results suggest that the effect of asset liquidity on leverage depends on a combination of its effects on both secured and unsecured debt. Study of Frank and Vidhan, 2009, shows that it is well known that in a leverage regression, profits are negatively related to leverage. The literature considers this to be a key rejection of the static trade-off theory. In this paper, they show that: 1.The literature has misinterpreted the evidence as a result of the wide-spread use of familiar but empirically misleading, leverage ratios. 2. More profitable firms experience an increase in both book equity and the market value of equity. 3. Empirically, they react as in the trade-off theory.

Highly profitable firms typically issue debt and repurchase equity, while low profitable firms typically reduce debt and issue equity. 4. Firm size matters. Large firms make more active use of debt, while small firms make more active use of equity. 5. In a trade-off model, financing decisions depend on market conditions (`market timing’). Empirically, poor market conditions result in reduced use of external finance. The impact is particularly strong on small and low profit firms. The data are constructed from the usual Compustat and CRSP databases.

The numbers are not surprising. The average debt (in constant US$) is about $477 million while the median is $14 million. A significant fraction of firms have zero debt (the 10th percentile is 0). Book equity is slightly larger than book debt. Market equity is more than two times larger than book debt. The connection between corporate profits and corporate capital structure has been very inertial in the assessment of the static trade-off theory. The standard evidence has pushed the literature away from the static trade-off, and towards much more complex models and ideas. As a result it is important to make sure that the evidence is correctly interpreted.

Unfortunately the literature has misinterpreted the data. This is due to the widespread use of leverage ratios. Such ratios have a number of undesirable features for testing the implications of the static trade-off theory. They illustrate that the impact of these features 16 is not limited to the tails of the data distributions.

Instead, the impact is observed even at the median of the data. Empirically, we show that more profitable firms tend to issue more debt and repurchase equity. Less profitable firms tend to do the reverse. Firm size also matters. Larger firms tend to be more active in the debt markets while smaller firms tend to be relatively more active in the equity markets.

More external financing is used in good times than in bad times. Overall, the empirical evidence on issuance seems rather easy to understand from the perspective of the static trade-off theory.

Cite this page