Ebook Do Tests of Capital Structure Theory Mean What They Say?
Recent empirical research in capital structure has focused on regularities in the cross section of leverage to distinguish between various theories of financing policy. Both book and market leverage are related to profitability, book-to-market, and firm size. Changes in market leverage are largely explained by changes in equity value. Past book-to-market ratios have been shown to predict current capital structure. Firms appear to use external debt financing too conservatively, with the leverage of stable, profitable firms being particularly low. Even if firms have a target level of leverage, they move towards it slowly, at a “snail’s pace” (Fama and French (2002)). Firms with low and high leverage react differently to external economic shocks. Existing explanations for these findings are related to various versions of the pecking order, trade-off or market timing theories. Each of these theories is supported by some evidence and challenged by other evidence. This paper attempts to reconcile these apparently conflicting results by providing a quantitative, as well as qualitative, connection between empirical cross-sectional studies of capital structure and dynamic models of optimal financing behavior.
The starting point is a simple but, I believe, powerful observation: in a dynamic economy with frictions the leverage of most firms, most of the time, is likely to deviate from “optimal leverage” prescribed by a model of optimal financial policy. With transaction costs optimizing shareholders will prefer to adjust leverage by issuing or retiring securities infrequently, at “refinancing points”. One simple consequence of this observation is that, even if firms follow a certain model of financing behavior, a static model may nonetheless fail to explain differences between firms in a cross-section since, between refinancing points, the actual and “optimal” leverage differ. It has been long recognized that deviations from optimal leverage may create problems for interpreting the results of empirical research. For example, Myers (1984, p. 578) emphasizes that “any cross-sectional test of financing behavior should specify whether firms’ debt ratios differ because they have different optimal ratios or because their actual ratios diverge from optimal ones”.
In this paper I reverse the standard approach. Instead on fixing on a methodology to distinguish between alternative theories, I fix the theory and ask how the results of existing empirical tests should be interpreted. Specifically, I construct a model of optimal dynamic corporate financing behavior in the presence of frictions and then ask whether, using data generated by this model, tests similar to those used in empirical studies replicate the empirical properties of firms’ financing policies that are found empirically. In a nutshell, my results can be summarized methodologically as follows: (i) cross-sectional tests performed on data generated by dynamic models can produce results that are profoundly different from their predictions for corporate financing behavior at refinancing points; moreover, some results would lead to the rejection of precisely the model on which these tests are based; and (ii) results of even a stylized trade-off model of dynamic capital structure with adjustment costs are consistent with those observed empirically, and some are able to replicate empirical results quantitatively. These results suggest that there is need both to rethink current empirical methodology and to develop dynamic models of financing capable of delivering quantitative predictions.
A prerequisite for my analysis is a model that captures the dynamics of firms’ financing behavior. Among many existing interesting explanations of capital structure only the trade-off argument has a fully-worked out dynamic theory that leads to quantitative predictions of leverage ratios in dynamics. In the trade-off theory firms arrive at their optimal capital structure by balancing the corporate tax advantage to debt with the bankruptcy and agency costs. The choice of the trade-off model might seem regrettable because there exist at best mixed empirical support for this model. However, as I show in the paper, empirical data seems to be more consistent with the trade-off theory than has been found to date, and so ex-post the choice might seem less regrettable. To this end, therefore, I take a standard state-contingent model of dynamic capital structure rooted in a trade-off argument. While several features differentiate the model from others in the field, the basic setup is widely used in the literature. In the model, firms are always on their optimal capital structure path even though, because of the presence of adjustment costs, they choose to refinance only occasionally. Apparently small adjustment costs can lead to large waiting times and large changes in leverage, a result consistent with findings of Fischer, Heinkel, and Zechner (1989). Firms that perform consistently well re-leverage to exploit the tax related benefits of debt. Firms that perform badly face a liquidity crisis and may sell their assets to pay down debt. If their financial condition deteriorates still further, they resort to costly equity issuance to finance their debt payments and, once all other possibilities are exhausted, they default and equity ownership is transferred to debt holders.
I use the model in two ways. First, I derive the conditions that determine the path of firm’s optimal financing decisions. This enables me to study the cross section of optimal leverage at times when firms change their leverage: I call these “refinancing points”. Naturally, when firms are at their refinancing points, all the comparative statics predictions of the model are in line with the predictions of the trade-off theory.
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