The finance literature has traditionally offered two theories of capital structure. In the tradeoff theory, firms pick target leverage by weighing the benefits and costs of an additional dollar of debt. The benefits of debt include the tax deductibility of interest and the reduction of the free cash flow problem (Jensen (1986)). The costs of debt include the expected financial distress costs and the costs arising from the agency conflict between shareholders and bondholders. At target leverage, the benefit of the marginal dollar of debt exactly equals the cost.
In the pecking order theory of Myers (1984), the costs of issuing new securities dominate other considerations. These costs arise because management possesses private information about the value of risky securities and uses this information when making issuing decisions. Because of these costs, firms use internal capital to finance new projects. When internal capital is insufficient, firms issue safe and then risky debt. Equity is issued as a last resort.
Despite significant research in this area, our understanding of capital structure decisions is far from complete. Neither theory is capable of explaining all regularities in capital structure decisions. Previous research has found leverage to be related to profitability, market-to-book, firm size, asset tangibility, and industry leverage in a manner consistent with either one or the other theory. It is not clear whether target leverage exists and, assuming that it does, there is disagreement about how quickly firms adjust to the target. Interestingly, firms are not inactive in their refinancing decisions but the decisions that they make appear to contradict either the tradeoff or the pecking order theory. Firms appear to fail to take full advantage of the tax deductibility of debt.
Firms also appear to fail to counteract the effects of stock prices on leverage, so changes in market leverage are significantly related to stock prices, and past market-to-book ratios predict current leverage. Empirical tests are further complicated by the fact that capital structure appears highly persistent in the time-series, which makes identification of factors relevant for capital structure decisions more challenging (Lemmon, Roberts, and Zender (2008)).
This paper attempts to address this challenge and further our understanding of capital structure dynamics by studying the evolution of capital structure in response to economic deregulation. Economic deregulation is a significant shock that considerably affects the operating environment of firms, so it is natural to ask whether and how capital structure evolves in response to such a shock. Because deregulation permanently and (at least in some industries) dramatically transforms the operating environment, capital structure should evolve in a non-trivial way unless it is strictly fixed or irrelevant. Thus, by documenting the capital structure response to changes in the operating environment brought by deregulation, I attempt to isolate factors that are important for leverage decisions.
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Capital Structure Decisions: Evidence from Deregulated Industries
