The effect of market conditions on capital structure adjustment
Introduction
There is growing attention to the manner in which firms adjust, or fail to adjust, their leverage. The adjustment pattern is of interest because it can help distinguish alternative theories of capital structure. We empirically examine the implications of three of these theories.
The first is the traditional trade-off theory, which states that corporate leverage is determined by managers making trade-offs between various costs and benefits of debt and equity, in particular tax savings (Graham, 2003) and deadweight costs of bankruptcy. As explained by Myers (1984), under this theory, managers undo the effects of shocks, causing the leverage ratio to be mean reverting.1
Welch (2003) has forcefully challenged this implication of the trade-off theory: “… US corporations do little to counteract the influence of stock price changes on their capital structures. … the stock price effects are considerably more important in explaining debt–equity ratios than all previously identified proxies together. Stock returns are the primary known component of capital structure and capital structure changes.” In Welch's view, shocks to the stock market affect capital structure but since firms do not take steps to reestablish a leverage target, the levels of debt and equity do not influence subsequent leverage adjustments.
Another challenge to the trade-off theory is known as the market timing theory. According to Baker and Wurgler (2002), the most realistic account of leverage is that it reflects the attempts by managers to time the equity market—issuing equity when the market is receptive. Presumably managers who time the equity market will also time the debt market. If market timing affects debt and equity issuance decisions, then measures of the equity market (the market-to-book ratio) and the debt market (the interest rate) ought to have significant impacts on changes in leverage.
Trade-off theory, market timing theory, and Welch's (2003) theory of capital structure all make claims about the determinants of adjustments to corporate debt and equity. In an effort to understand which approach seems most realistic, we study aggregate US data from 1952 to 2000. The use of aggregate-level data is a natural place to start since the basic corporate adjustment pattern can be easily identified.
Many studies of capital structure, such as Frank and Goyal (2003b), examine leverage ratios. When studying the leverage adjustment path, examining leverage ratios has the undesirable effect of precluding an examination of whether observed leverage changes reflect debt or equity adjustments. For this reason, we use a Vector Autoregression (VAR) framework in which debt and equity adjustments are analyzed separately rather than in the form of a leverage ratio.2
Empirically, deviations from the long run equilibrium actually affect debt adjustments but they do not affect equity adjustments. Market conditions seem to affect the debt adjustment process but they do not have much impact on equity adjustments. The evidence of a long-run relationship between debt and equity is consistent with the predictions of trade-off theory.3
Section snippets
Data
We construct the series on aggregate debt, aggregate market value of equity, and average market-to-book from the Compustat database. The data consists of non-financial US firms over the years 1952–2000. These data are annual and are converted into 1992 dollars using the GDP deflator. Total debt (DEBT) is the sum of debt in current liabilities (#34) and long-term debt (#9). Market value of equity (MVE) is obtained by multiplying closing stock prices (#199) by shares outstanding (#54).4
VAR estimation
Consider a VAR(1) model of debt and equity.6 Let DEBTt denote debt at date t, ln the natural log and Δ a one-period time difference. Let MVEt denote the market value of equity at date t, MBt denote the market-to-book ratio, and rt denote the going interest rate, which we take to be the
Nonstationarity
VAR models such as those reported in columns 1 and 2 of Table 2 are sometimes criticized on the grounds that they rest on an assumption of stationarity which might not be valid.8 We have only 49 years of data. It is thus difficult to
Conclusion
This paper uses a VAR approach to examine the aggregate corporate leverage adjustment process over the period from 1952 to 2000. Trade-off theory predictions are compared to the predictions of market timing and to the claims made by Welch (2003).
Market conditions, as measured by the market-to-book ratio, matter for leverage adjustments. If the market-to-book ratio is high in a given year then a reduction in debt follows in the next year. A high market-to-book ratio does not significantly
Acknowledgements
We thank Vojislav Maksimovic and Toni Whited for helpful comments. We alone are responsible for any errors. Murray Frank thanks the BI Ghert Family Foundation and the SSHRC for financial support. Vidhan Goyal acknowledges research support from HKUST research Grant DAG03/04.BM46.
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