Determinants of Financial Structure: a New Methodological Approach

TLDR: In this article, the authors investigate the relationship between a firm's financial structure and its industrial class, size, variability of income, and operating leverage, and propose a taxonomy of firms that is based on the firms' actual financial behavior.

Abstract: THE ASSOCIATION BETWEEN A firm's financial structure and its operating characteristics-its industrial classification and its size, among others-took on added importance as a result of the debate, started by Modigliani and Miller [8], regarding cost of capital and optimal structure. Impressive evidence that industrial class influences financial structure has been marshalled by Scott [12] and Scott and Martin [13]. Support for the view that size might shape a firm's debtequity mix may be found in Scott and Martin [13]. However, dissenting evidence has been presented, most notably by Remmers, Stonehill, Wright and Beekhuisen [11] who argue that neither size nor industry is clearly a determinant of the firm's use of debt. The aim of this paper is 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. This paper's investigation of the determinants of financial structure will be performed through the examination of four specific hypotheses. The first hypothesis is concerned with the relationship between industrial classification and financial leverage. The view that industry class has an impact on financial leverage has intuitive appeal. Firms in the same industry class should experience similar amounts of business risk, because these firms produce similar products, face similar costs for materials and skilled labor, and rely on similar technology. Business risk-the uncertainty of future income streams-should substantially determine the amount of debt the capital markets will provide. The markets set interest rates and maximal debt loads by reference to the volatility of a firm's income stream. Because this volatility should be related to the products of the firm, there is reason to believe that financial structure is molded by a firm's industrial classification. The evidence, cited earlier, that industry type does not