Showing papers on "Capital structure published in 2005"

Do Firms Rebalance Their Capital Structures

Abstract: We empirically examine whether firms engage in a dynamic rebalancing of their capital structures while allowing for costly adjustment. We begin by showing that the presence of adjustment costs has significant implications for corporate financial policy and the interpretation of previous empirical results. After confirming that financing behavior is consistent with the presence of adjustment costs, we find that firms actively rebalance their leverage to stay within an optimal range. Our evidence suggests that the persistent effect of shocks on leverage observed in previous studies is more likely due to adjustment costs than indifference toward capital structure. A TRADITIONAL VIEW IN CORPORATE FINANCE is that firms strive to maintain an optimal capital structure that balances the costs and benefits associated with varying degrees of financial leverage. When firms are perturbed from this optimum, this view argues that companies respond by rebalancing their leverage back to the optimal level. However, recent empirical evidence has led researchers to question whether firms actually engage in such a dynamic rebalancing of their capital structures. Fama and French (2002), among others, note that firms’ debt ratios adjust slowly toward their targets. That is, firms appear to take a long time to return their leverage to its long-run mean or, loosely speaking, optimal level. Moreover, Baker and Wurgler (2002) document that historical efforts to time equity issuances with high market valuations have a persistent impact on corporate capital structures. This fact leads them to conclude that capital structures are the cumulative outcome of historical market timing efforts, rather than the result of a dynamic optimizing strategy. Finally, Welch (2004) finds that equity price shocks have a long-lasting effect on corporate capital structures as well. He concludes that stock returns are the primary determinant of capital structure changes and that corporate motives for net issuing activity are largely a

How and When Do Firms Adjust Their Capital Structures Toward Targets

Abstract: If firms adjust their capital structures toward targets, and if there are adverse selection costs associated with asymmetric information, how and when do firms adjust their capital structures? We suggest a financing-needs-induced adjustment framework to examine the dynamic process by which firms adjust their capital structures. We find that most adjustments occur when firms have above-target debt with a financial surplus or when they have below-target debt with a financial deficit. These results suggest that firms move toward the target capital structure when they face a financial deficit/surplus --- but not in the manner hypothesized by the traditional pecking-order theory.

Debt Financing: Does it Boost or Hurt Firm Performance in Product Markets?

Abstract: Research on capital structure-product market interactions has traditionally sought to establish whether debt financing either hurts or boosts firm performance. This paper proposes that both of these competitive outcomes are likely to emerge in an industry setting: debt can hurt and boost a firm's product market performance. To motivate this case, I analyze a simple model implying a non-monotonic relation between a firm's use of external (debt-like) financing and its competitive conduct. I then empirically examine the within-industry relation between corporate debt and sales performance using firm-level data from a panel of 115 industries over 30 years. The testing strategy I implement allows for the marginal effect of debt policies on product market outcomes to vary according to the level of firm/rival indebtedness. Crucially, it addresses concerns with the endogeneity of financing decisions in a novel fashion: I use creditors' valuation of firms' assets in liquidation to identify financial leverage in an empirical model of product market performance. My evidence suggests that moderate (relative-to-industry) firm debt taking is, on the margin, associated with sales gains that obtain at the expense of industry rivals. After some point, however, higher relative indebtedness leads to significant sales underperformance. I also investigate whether financing-performance linkages vary with industry concentration and with firm leadership (market share size). I find that leader (follower) firms in concentrated industries underperform (outperform) their rivals when those firms' leverage ratios exceed the industry norm. In contrast, less leveraged leaders in those same industries observe positive sales-debt sensitivities. Firm debt and leadership positions are less relevant for competitive outcomes in less concentrated markets.

Managerial Stock Ownership and the Maturity Structure of Corporate Debt

Abstract: This study documents that managerial stock ownership plays an important role in determining corporate debt maturity. Controlling for previously identified determinants of debt maturity and modeling leverage and debt maturity as jointly endogenous, we document a significant and robust inverse relation between managerial stock ownership and corporate debt maturity. We also show that managerial stock ownership influences the relation between credit quality and debt maturity and between growth opportunities and debt maturity. THE IMPORTANCE OF LEVERAGE AND DEBT MATURITY STRUCTURE CHOICE in alleviating manager‐shareholder agency conflicts is well recognized in the finance literature. These vital decisions are at the discretion of top managers who are expected to make optimal (value-maximizing) financing choices on behalf of the shareholders. However, given the separation of ownership and control, managers cannot be expected to voluntarily choose the optimal debt maturity structure or leverage and self-impose monitoring unless there is an incentive mechanism to align managerial and shareholder interests. It is clear, therefore, that these decisions themselves are subject to an agency problem of managerial discretion. Managerial stock ownership can be effective in aligning the interests of managers and shareholders to mitigate such agency problems (see, e.g., Jensen and Meckling (1976)). We argue that the conflict between managers and shareholders over the maturity structure of debt arises from the inherent preference of self-interested managers for less monitoring. Our study adds a new dimension to the recently growing body of literature on capital structure choice in the presence of agency conflicts. By examining how managerial stock ownership determines corporate debt maturity structure, we provide evidence on an important, yet unaddressed, issue that is at the confluence of the capital structure and corporate governance literatures. Earlier capital structure studies emphasize the role of debt in reducing agency problems between managers and shareholders (see, e.g., Jensen and

How SME Uniqueness Affects Capital Structure: Evidence From A 1994–1998 Spanish Data Panel

Abstract: The principal aim of this paper is to test how firm characteristics affect Small and Medium Enterprise (SME) capital structure. We carry out an empirical analysis of panel data of 6482 non-financial Spanish SMEs during the five years period 1994–1998, modelling the leverage ratio as a function of firm specific attributes hypothesized by capital structure theory. Our results suggest that non-debt tax shields and profitability are both negatively related to SME leverage, while size, growth options and asset structure influence positively SME capital structure; they also confirm a maturity matching behaviour in this firm group.

The capital structure of Swiss companies: an empirical analysis using dynamic panel data

Abstract: In this paper, we analyse the determinants of the capital structure for a panel of 104 Swiss companies listed in the Swiss stock exchange. Dynamic tests are performed for the period 1991–2000. It is found that the size of companies and the importance of tangible assets are positively related to leverage, while growth and profitability are negatively associated with leverage. The sign of these relations suggest that both the pecking order and trade-off theories are at work in explaining the capital structure of Swiss companies, although more evidence exists to validate the latter theory. Our analysis also shows that Swiss firms adjust toward a target debt ratio, but the adjustment process is much slower than in most other countries. It is argued that reasons for this can be found in the institutional context.

An Empirical Investigation of the Growth Cycle Theory of Small Firm Financing

Abstract: This paper empirically tests the financial growth cycle model for small and medium-sized enterprises (SMEs), which postulates that as firms become larger, older, and more informationally transparent, their financing options become more attractive. We add to the literature by providing one of the first empirical tests of the model using a large, cross-sectional data set. Our results partially support the financial growth cycle model. Specifically, our results show larger firms, as measured by total number of employees, are more likely to use public equity funding or long-term debt as opposed to insider funding. Introduction Interest in small and medium enterprises (SMEs) has increased significantly over the last decade. Even before the recent surge in entrepreneurial ventures, SMEs contributed greatly to the U.S. economy, producing between 40 and 60 percent of the U.S. gross national product and employing about 50 percent of the workforce (Neubauer and Lank 1998). Much of the attention surrounding growth in the smaller firm has focused on capital structure decisions, because problems related to financing are dominant in the small and young firm (Terpstra and Olson 1993). The literature is rich with anecdotal and empirical studies describing inadequate financial resources as a primary cause of SME failure (Coleman 2000; Van Auken and Neeley 1996; Gaskill and Van Auken 1993; Welsch and White 1981; Jones 1979; and Wucinich 1979). Small businesses differ from larger firms in terms of capital structure decisions. Their reliance on private markets limits the types of financing they can receive. This, coupled with the small firm's initial use of internal sources of capital, creates a unique situation in which capital structure decisions are made. It is widely accepted that small firms have different optimal capital structures and are financed by various sources at different stages of their organizational lives (Berger and Udell 1998). The novelty of a small business's options for raising capital has spurred a line of research focusing on the specific characteristics of small firms that may contribute to the capital structuring decision. The most widely accepted view of small-business capital structure is that of Berger and Udell's (1998) financial growth cycle model. Other researchers have found that specific attributes of small firms impact the types of funds used to finance the firm's operations, (for example, Romano, Tanewski, and Smyrnios 2001; Hall, Hutchinson, and Michaelas 2000; Van Auken and Neeley 1996); however, the Berger and Udell (1998) work, which proposes that optimal capital structures vary at specific threshold points, seems to have captured the attention of most researchers. Specifically, Berger and Udell (1998) contend that changes in optimal capital structure are a function of the firm size, age, and information availability. In this paper, we empirically test Berger and Udell's (1998) model on a sample of 954 U.S.-based SMEs, using firm-level data. Although much interest has arisen in SME capital structure decisions, we found no research that specifically tests the Berger and Udell model on a large sample of cross-sectional data. Thus, we contribute to the literature by providing an empirical foundation for this widely held model on SME capital structure decisions. We begin with a discussion of the financial growth cycle model. Berger and Udell's Financial Growth Cycle Model Berger and Udell (1998) propose a financial growth cycle for small businesses where the financial needs and financing options change as the business grows, becomes more experienced and less informationally opaque (Figure 1). They further suggest that firms lie on a size/age/information continuum where the smaller/younger/more opaque firms "lie near the left end of the continuum indicating that they must rely on initial insider finance, trade credit, and/or angel finance" (Berger and Udell 1998, p. …

Do Firms Target Credit Ratings or Leverage Levels

Abstract: Firms reduce leverage following credit rating downgrades. In the year following a downgrade, downgraded firms issue approximately 1.5-2.0% less net debt relative to net equity as a percentage of assets compared to other firms. This relationship persists within an empirical model of target leverage behavior. The effect of a downgrade is larger at downgrades to a speculative grade rating and if commercial paper access is affected. In particular, firms downgraded to speculative are about twice as likely to reduce debt as other firms. Rating upgrades do not affect subsequent capital structure activity, suggesting that firms target minimum rating levels.

Taxes, Leverage, and the Cost of Equity Capital

Abstract: We examine the associations between leverage, corporate and investor level taxes, and the firm's implied cost of equity capital. Expanding on Modigliani and Miller [1958,1963], the cost of equity capital can be expressed as a function of leverage and corporate and investor level taxes. This expression predicts that the cost of equity is increasing in leverage, but that corporate taxes mitigate this leverage related risk premium, while the personal tax disadvantage of debt increases this premium. We empirically test these predictions using implied cost of equity estimates and proxies for the firm's corporate tax rate and the personal tax disadvantage of debt. Our results suggest that the equity risk premium associated with leverage is decreasing in the corporate tax benefit from debt. We find some evidence that the equity risk premium associated with leverage is increasing in the personal tax penalty associated with debt.

Pecking order or trade-off hypothesis? Evidence on the capital structure of Chinese companies

Abstract: This study tests the pecking order and trade-off hypotheses of corporate financing decisions using a cross-section of the largest Chinese listed companies. The study is built on Allen (1993), Baskin (1989) and Adedeji (1998) to set up three models in which trade-off and pecking order theories give distinctively different predictions: (1) the determinants of leverage; (2) the relationship between leverage and dividends; and (3) the determinants of corporate investment. In model 1, a significant negative correlation is found between leverage and profitability; in model 2 a significant positive correlation between current leverage and past dividends is found. These results broadly support the pecking order hypothesis over trade-off theory. However, model 3 is inconclusive. Overall, the results provide tentative support for the pecking order hypothesis and demonstrate that a conventional model of corporate capital structure can explain the financing behaviour of Chinese companies.

Real options, agency conflicts, and optimal capital structure

Abstract: We examine the impact of a stockholder–bondholder conflict over the timing of the exercise of an investment option on firm value and corporate financial policy. We find that an equity-maximizing firm exercises the option too early relative to a value-maximizing strategy, and we show how this problem can be characterized as one of overinvestment in risky investment projects. Equityholders’ incentive to overinvest significantly decreases firm value and optimal leverage, and significantly increases the credit spread of risky debt. Numerical solutions illustrate how the agency cost of overinvestment and its effect on corporate financial policy vary with firm and project characteristics.

Optimal Capital Structure and Industry Dynamics

Abstract: This paper presents an equilibrium model of industry dynamics and capital structure decisions. The unique stationary equilibrium is derived in closed-form. The analysis reveals that the interaction between capital structure and production decisions influences the stationary distribution of surviving firms and their survival probabilities. Under reasonably calibrated parameter values, the model predicts a low industry average leverage ratio which is in line with that observed in practice. Comparative static analysis demonstrates that the model can generate the relation between capital structure and firmsi¯ entry, exit and production decisions documented in the evidence. The model also provides a number of new predictions regarding industry dynamics and capital structure.

The Capital Structure Puzzle: The Evidence Revisited

Abstract: Since the formulation of the M&M propositions almost 50 years ago, financial economists have been debating whether there is such a thing as an optimal capital structure—a proportion of debt to equity that maximizes shareholder value. Some finance scholars have followed M&M in arguing that both capital structure and dividend policy are largely “irrelevant” in the sense that they have no significant, predictable effects on corporate market values. Another school of thought holds that corporate financing choices reflect an attempt by corporate managers to balance the tax shields and disciplinary benefits of greater debt against the costs of financial distress. Yet another theory says that companies do not have capital structure targets, but simply follow a financial “pecking order” in which retained earnings are preferred to outside financing, and debt is preferred to equity when outside funding is required. In reviewing the evidence that has accumulated since M&M, the authors argue that taxes, bankruptcy (and other “contracting”) costs, and information costs all appear to play an important role in corporate financing decisions. While much of the evidence is consistent with the argument that companies set target leverage ratios, there is also considerable support for the pecking order theory's contention that firms are willing to deviate widely from their targets for long periods of time. According to the authors, the key to reconciling the different theories—and thus to solving the capital structure puzzle—lies in achieving a better understanding of the relation between corporate financing stocks (the levels of debt and equity in relation to the target) and flows(or which security to issue at a particular time).

Horses and Rabbits? Trade-Off Theory and Optimal Capital Structure

Abstract: This paper examines optimal capital structure choice using a dynamic capital structure model that is calibrated to reflect actual firm characteristics. The model uses contingent claim methods to value interest tax shields, allows for reorganization in bankruptcy, and maintains a long-run target debt to total capital ratio by refinancing maturing debt. Using this model, we calculate optimal capital structures in a realistic representation of the tra ditional trade-off model. In contrast to previous research, the calculated optimal capital structures do not imply that firms tend to use too little leverage in practice. We also esti mate the costs borne by a firm whose capital structure deviates from its optimal target debt to total capital ratio. The costs of moderate deviations are relatively small, suggesting that a policy of adjusting leverage infrequently is likely to be reasonable for many firms.

The Determinants of Capital Structure: Evidence from Chinese Listed Companies

Abstract: This paper attempts to investigate the determinants of the capital structure of a sample of 972 listed companies on the Shanghai Stock Exchange and Shenzhen Stock Exchange in China in 2003. Various theories, namely, the trade-off, pecking order and agency theories, are deployed to explain and predict the signs and significance of each factor identified by Ragan and Zingales (1995) and Booth et al. (2001). Furthermore, we include institutional shareholdings, including state agency shareholdings, state-owned shareholdings and privately owned shareholdings, as corporate governance variables to examine the effects of corporate structure on the debt financing behaviours. As well documented, we find that profitability is negatively related to capital structure at a highly significant level. The size and risk of the firms are positively related to the debt ratio ? but only in term of market value measures of capital structure. The years of the companies being listed on stock markets are positively related to capital structure, indicating the access of the firms to debt finance is more easily judged by book value. Tax is not a factor in influencing debt ratio. Ownership structure has a negative effect on the capital structure. The firms with higher institutional shareholdings tend to avoid using debt financing, a behaviour that can be explained by entrenchment effects. A further classification of the institutional shareholders reveals that, among the three groups of institutional shareholding, the state institutions, including state agency and state-owned institutions, were more averse to debt financing, particularly for state-owned institutions. There is no strong evidence indicating debt-averse behaviour by domestic institutional shareholders.

Tax Shelters and Corporate Debt Policy

Abstract: We use a novel sample of 44 tax shelter cases involving public corporations to investigate which types of firms shelter, the magnitude of the tax shelters they use, and whether participating in a shelter affects corporate debt policy. The propensity to shelter increases with firm size, profitability, R&D expenditures, foreign operations, and the market to book ratio. The average deduction produced by the shelters in our sample is very large, equaling approximately nine percent of asset value. This is about three times as large as interest deductions for comparable firms. Our results suggest that corporations substitute away from debt when using tax shelters. Seven years before they engage in sheltering activity, shelter firms have mean debt ratios of about 25 percent, roughly equivalent to matched firm debt ratios. By the year of the sheltering activity, shelter firm debt ratios have fallen to approximately 18 percent while matched firm debt ratios have not fallen. These results help explain why some firms appear to be under-levered when tax-sheltering activity is ignored, and also why corporate tax payments have fallen so precipitously in recent years.

Taxation and the Financial Structure of German Outbound FDI

Abstract: The paper analyzes the financial structure of outbound FDI during the period 1996-2002 by drawing on up to 54,022 firm-year observations of 13,758 German-owned subsidiaries. We find that the tax rate in the host country has a sizeable and significantly positive effect on leverage for wholly-owned foreign unlike partially-owned foreign companies. Most of the effect comes from increased intra-company borrowing, while third-party debt is not significantly affected by tax differences. While wholly-owned subsidiaries react more sensitively to tax rate differentials, they are less sensitive to macroeconomic influences like interest rates.

Corporate Finance: Theory and Practice

Abstract: Corporate Finance: Theory and Practice covers the theory and practice of Corporate Finance from a truly European perspective It shows how to use financial theory to solve practical problems and is written for students of corporate finance and financial analysis and practising corporate financiers Corporate Finance is split into four sections and covers the basics of financial analysis

Financial Viability Analysis and Capital Structure Optimization in Privatized Public Infrastructure Projects

Abstract: Numerous public infrastructure projects have been privatized worldwide, where responsibilities, risks, and rewards are substantially reallocated between pubic and private sectors. The financial evaluation of a privatized infrastructure project is complex and challenging because of the risks and uncertainties due to the large size, long contract duration, nonrecourse financing, multiple project participants with different motives and interest, and the complexity of the contractual arrangements. Improved financial engineering techniques are required to overcome the limitations of traditional financial analysis techniques in addressing risks and uncertainties. This paper develops a methodology for capital structure optimization and financial viability analysis that reflects the characteristics of project financing, incorporates simulation and financial engineering techniques, and aims for win-win results for both public and private sectors. This quantitative methodology defines the capital structure of a privatized project in four dimensions, examines different project participants' perspectives of the capital structure, optimizes the capital structure, and evaluates the project's financial viability when it is under construction risk, bankruptcy risk and various economic risks (that are dealt with as stochastic variables), and is subject to other constraints imposed by different project participants. This methodology also evaluates the impact of governmental guarantees and supports, and addresses the issue of the equity holders' commitment to project success by initiating the concepts of equity at project risks, value of governmental loan guarantee, and project bankrupt probability during construction. A framework and a solution algorithm are provided for this proposed methodology. These research outputs will significantly facilitate both public and private sector in evaluating a privatized project's financial viability and collectively determining an optimal capital structure that safeguards their respective interests.

Ultimate Corporate Ownership Structures and Capital Structures: Evidence from East Asian Economies

Abstract: This paper studies the relationship between corporate leverage and the ultimate corporate ownership structure, particularly the separation of cash flow rights and control rights. We empirically disentangle the three potential effects of the divergence of control rights from cash flow rights on corporate leverage, i.e. the non-dilution entrenchment effect, the signalling effect of debt and the reduce-debt-for-tunnelling effect. Our evidence from the East Asian corporations mainly supports the notion that controlling shareholders with relatively small ownership share tend to increase leverage out of the motive of raising external finance without diluting their shareholding dominance. The separation of cash flow rights and control rights contributes to the risk-taking tendency of the large controlling shareholders in capital structure choice. We argue that the risky capital structure choice serves as one potential channel through which weak corporate governance contributes to the severity of corporate value losses during the Asian financial crisis.

Corporate Dividend Policy: The Views of British Financial Managers

Abstract: Using a survey approach, this paper examines the importance and relevance of the various theories of dividend policy for UK companies. Further, it evaluates the extent to which corporate characteristics such as size and industry influence managerial responses to the survey. In general, the results support dividend hypotheses relating to signalling and ownership structure, in preference to those about capital structure and investment decisions and agency issues. At a more detailed level, the cross sectional analysis reveals important differences between managers’ responses, based on company size, industry sector, growth opportunities, ownership structure and information asymmetry.

The determinants of capital structure for Australian Multinational and domestic corporations

Abstract: This study considers the significance of the determinants of capital structure on a sample of Australian multinational and domestic corporations from 1992 to 2001. The results show that the level o...

Ultimate Corporate Ownership Structures and Capital Structures: evidence from East Asian economies

Abstract: This paper studies the relationship between corporate leverage and the ultimate corporate ownership structure, particularly the separation of cash flow rights and control rights. We empirically disentangle the three potential effects of the divergence of control rights from cash flow rights on corporate leverage, i.e. the non-dilution entrenchment effect, the signalling effect of debt and the reduce-debt-for-tunnelling effect. Our evidence from the East Asian corporations mainly supports the notion that controlling shareholders with relatively small ownership share tend to increase leverage out of the motive of raising external finance without diluting their shareholding dominance. The separation of cash flow rights and control rights contributes to the risk-taking tendency of the large controlling shareholders in capital structure choice. We argue that the risky capital structure choice serves as one potential channel through which weak corporate governance contributes to the severity of corporate value losses during the Asian financial crisis.

Finance and Innovation: The Case of Publicly Traded Firms

Abstract: We hypothesize that public firms that create novel innovations rely more on arm's length financing (equity and public debt) than on relationship based bank financing. A primary reason is that banks, unable to evaluate novel technologies, will tend to discourage investing in innovative projects and be more prone to shut down ones that are ongoing. Using a large panel of US companies from 1974-2000, we find that consistent with our predictions, firms that rely more on arm's length financing have a larger number of patents and these patents are more significant in terms of influencing subsequent patents. We confirm our findings by showing a significant increase in innovative activity of firms following a large infusion of arm's length financing and no such pattern after a similar infusion of bank loans. Creating novel innovations leads to a significantly higher firm value and suggests that firms would rationally take into account the potential impact of innovative activity when making their financing choices. Finally, we use an IV approach to ameliorate endogeneity concerns and demonstrate that our findings are driven primarily by innovative firms choosing their financing arrangements.

Capital Structure, Environmental Dynamism, Innovation Strategy, and Strategic Risk Management

Abstract: Previous research found that capital structure affects performance when it is adapted to the level of environmental dynamism and pursuit of an innovation strategy. The current study reproduces some of these relationships in a more recent dataset but also identifies significant nuances across industrial environments. Analyses of a large cross sectional sample and various industry sub-samples suggest that other factors have influenced capital structure effects in recent years including flexibilities in multinational organization and effective strategic risk management capabilities.