Do markets anticipate capital structure decisions? — Feedback effects in equity liquidity☆,☆☆
Introduction
What are the determinants of capital structure? This has been one of the most enduring and challenging questions in the corporate finance literature since the pioneering works of Modigliani and Miller (1958) and Myers (1984). Most studies on this topic have investigated certain firm characteristics (e.g., profitability, tangibility, size) or country and industry effects as determinants of leverage or the speed of adjustment toward a target capital structure. Our analysis focuses on the information revealed by the process that firms take toward these targets.
In this sense, we posit that managers (or “insiders”) have reasonably well-defined policies by which they adjust their firm's capital structure towards a long run target. Capital structure is normally stable over time (see Lemmon et al., 2008), until some type of change in, e.g., the financial environment makes an adjustment necessary (see Korajczyk and Levy, 2003). By comparing current capital structure with target leverage, we can predict future financial securities issuances (e.g., seasoned equity or bond offerings). If the issuance realized deviates from expectations, this information can be a valuable sign for market participants (“outsiders”) because it affects information asymmetries. However, the inherent information content of future issuances can also be estimated today using current equity liquidity, which we assume can proxy for asymmetric information.
The cash flow information hypothesis of Ross (1977) states that more profitable firms can afford higher debt. Previous work has tested this hypothesis, but only for observed changes in capital structure. Masulis (1980) and Erwin and Miller (1998) use event studies to measure the effect of leverage signaling on short-term returns. Dann et al. (1991) and Shah (1994) analyze firm performance after capital structure transactions by measuring, e.g., operating cash flow. Other authors, such as Ofer and Siegel (1987) or Israel et al. (1989), have examined adjustments of financial analysts' forecasts in response to leverage signaling.3
In contrast, we use expected changes in leverage, denoted as “target leverage changes”, proxied for by estimated changes in capital structure from leverage regressions. We believe that this is a sound method, because investors use available information to form expectations about firms' future performance and risk. From the pioneering works of Merton (1973) and Modigliani and Miller (1958), we know that firm leverage is related to both. Therefore, market participants should also develop expectations about future capital structure.
Our work deviates from the previous literature in a second key aspect, because we measure information revelations by using liquidity. We thus avoid using analyst coverage, which can be affected by conflicts of interest (see, e.g., Lin and McNichols, 1998, Michaely, 1999) or the reliability of analyst data in general, as pointed out by Ljungqvist et al. (2009). Furthermore, we do not need to rely on static balance sheet items such as size or growth opportunities, which are potentially driven by accounting policy and cannot react as quickly as equity liquidity.
We thus propose equity liquidity, although imperfect, as a viable proxy for measuring information asymmetries between managers (insiders) and the remaining market participants (outsiders). In the market microstructure literature, asymmetric information between traders as an illiquidity source has been modeled and discussed extensively (see, e.g., Brennan and Subrahmanyam, 1996, Easley and O'Hara, 1987, Foster and Viswanathan, 1993, Glosten, 1989, Kyle, 1985).4
In our case managers are well-informed. They have improved capabilities in the assessment of good (bad) news on their own firm and are more likely to buy (sell) larger volumes of stocks to use their information advantage. Therefore, market makers who step in if orders fail to arrive will lose money (Bagehot, 1971). In awareness of these expected losses, trading volume will either be reduced, or higher discounts in the form of spreads or price impacts will be expected (Amihud et al., 2006). The classic adverse selection problem described by Akerlof (1970) is a direct consequence. So we propose that liquidity should proxy for managers' information advantages about a firm's future prospects.
As per Bharath et al. (2009), our argument is based on the assumption that managers constitute a subgroup of informed traders for three reasons: 1) They naturally have access to insider information, 2) they own a considerable amount of shares in the company, and 3) they trade in their own firms' stocks. The first argument is common sense. Regarding (2), studies have shown that management compensation usually includes granted common stock and stock option awards (Agrawal and Mandelker, 1987, Jensen and Meckling, 1976, Yermack, 1995). As Morck et al. (1988) show, these instruments can amount to a considerable share of the firm. (3) comes from the results of several studies on company executives' and directors' trades that find that they use their information for trading and tend to earn abnormal returns (Finnerty, 1976, Jaffe, 1974, Jeng et al., 2003, Lakonishok, 2001).
We therefore propose using liquidity, despite its imperfections, as a proxy for the market's view on information asymmetries between insiders and outsiders. Higher informational asymmetries involve less liquidity, and liquidity measures are sensitive to information-revealing firm characteristics such as ownership structure (Gompers and Metrick, 2001), asset liquidity and ratings (Odders-White, 2006), events such as takeover announcements (Jennings, 1994) and agency costs (Hirth and Uhrig-Homburg, 2010). Moreover, firms with less liquid equity (and therefore most likely higher information asymmetries) exhibit higher levels of debt (Baker and Stein, 2004, Butler et al., 2005).
In summary, linking liquidity to corporate capital structure can yield valuable insights into three related strands of literature. First, we analyze the signaling effect of anticipated (targeted) leverage changes. We therefore contribute to the discussion on whether (unexpected) changes in leverage convey information to the public from an innovative perspective. Second, we expand the work of Bharath et al. (2009) by analyzing the entire chain from information asymmetries to (target) leverage, as well as its feedback effects to information asymmetries. Third, we improve the understanding of the drivers of liquidity. For owners and managers, this is extremely relevant, because liquidity has a direct effect on equity returns (see, e.g., Acharya and Pedersen, 2005, Amihud, 2002, Pastor and Stambaugh, 2003), the cost of capital, and thus shareholder value. Amihud and Mendelson, 1986, Amihud and Mendelson, 1988, Amihud and Mendelson, 2008, for example, have regularly called for an analysis of the link between capital structure and liquidity. For academia, it is also valuable to better understand the variations in liquidity that have been observed in the cross-section of firms and over time by Chordia et al., 2000, Chordia et al., 2001, Hasbrouck (2001) and Huberman and Halka (2001). In this context, our paper also contributes to the empirical literature on the relationship between equity liquidity and capital structure. As documented by Lipson and Mortal (2009) firms with more liquid equity use less debt and prefer equity when raising outside capital. Frieder and Martell (2006) go further and analyze the bi-directional relationship between leverage and liquidity using an instrumental variable approach. Their findings indicate that bid–ask spreads decrease as a reaction to increases in leverage. This is in line with lower agency costs induced by debt (Jensen (1986)) and Amihud and Mendelson's (1989) notion that managers also consider a potentially detrimental effect of illiquidity on firm value when making capital structure decisions. Our results extend this literature along two dimensions. First, when interpreting our information asymmetry index more broadly, our findings indicate that (unexpected) changes in capital structure affect firm-level liquidity. In other words, we extend the literature beyond observed changes by considering target leverage changes. Second, we complement the findings by Lipson and Mortal (2009) and Frieder and Martell (2006) by providing empirical evidence that decreases in leverage (through SEOs) lead to decreases in liquidity, which we interpret as increases in information asymmetry.5
To test the link between capital structure and information asymmetry, we use daily stock and annual balance sheet data for U.S. firms from 1989 through 2008. Our procedure encompasses four steps:
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Using a principal component analysis, as per Bharath et al. (2009), we derive the common informational component of six different liquidity measures.
- 2.
We then use the resulting year-by-year information asymmetry index to estimate (book and market) leverage targets, as is commonly done in the literature (see Rajan and Zingales, 1995, Titman and Wessels, 1988). Here, we find that leverage is a linear function of our information asymmetry index, and that an increase (of information asymmetry) by one standard deviation results in an increase in leverage of about 2%.
- 3.
Next, we calculate the distance between a firm's current leverage and its target capital structure as a proxy for expected development. We also demonstrate its reliability for predicting true changes.
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Finally, we determine the effect of these target leverage changes on our information asymmetry index (measures of liquidity), in order to model feedback effects.
Note that steps (2)–(4) yield a two-stage system estimation. If we use observed (i.e. realized) changes in leverage to explain changes in information asymmetry, we find diverging signs for the coefficients for book and market leverage in similar estimations. This is a consequence of endogeneity between market prices (and thus market leverage) and liquidity (used for our index). To address the endogeneity problem inherent in an estimation of the relation between information asymmetry and leverage, we therefore use the instrument obtained in step 3. We find that target leverage changes reduce our information asymmetry index by a significant amount, a factor ranging from − 0.25 to − 0.29. We take both results to mean that market participants anticipate capital structure decisions of managers, which is reflected in our information asymmetry index. Targeted increases in leverage tend to also increase liquidity, which supports Ross's (1977) signaling hypothesis.
For robustness, we estimate results for several indexes constructed on liquidity risk measures and for single measures of liquidity. Further we find that our results are even stronger if we ignore small changes in leverage. We control for the latter, because small changes in capital structure due to, e.g., maturing bonds that require refinancing, should not reveal any significant information to market participants.
As an alternative approach – and to further mitigate endogeneity concerns – we conduct a series of event studies of capital structure changes. Specifically, we examine the effect of announcements of seasoned equity offerings (SEOs) for all components of our information asymmetry index. By using SEOs, we are looking at negative changes in leverage (i.e. decreases in the relative amount of debt in a firm's capital structure). All event study results (except round trip transaction costs) are in line with the findings above, showing increases in information asymmetry as a result of expected decreases in leverage. Again, these results are in line with Ross (1977) in that lower expected leverage signals lower predictability of cash flows. Alternatively, the decrease in liquidity we observe could be due to an increase in agency costs. In line with Jensen (1986) market participants may be concerned that the (relative) decrease in disciplining debt may lower managerial discipline.
The remainder of the article proceeds as follows. Section 2 describes our data sources, sample construction, and definitions. In Section 3, we present our information asymmetry index. Section 4 contains our empirical analysis. Section 4.2 describes the determination of leverage targets, while Section 4.3 discusses their effect on information asymmetries. Section 4.4 presents our event study results. In Section 5, we conduct robustness checks. Section 6 gives our conclusions.
Section snippets
Database and sample construction
All of the daily stock data we use come from the Center for Research in Security Prices (CRSP) North America database.6 Included are U.S. stocks listed on the New York Stock Exchange (NYSE), the American Stock Exchange (AMEX), and the National Association of Securities Dealers Automated Quotations (NASDAQ). We limit
Liquidity and information asymmetry index
Our analysis concentrates solely on equity liquidity for several reasons. First, bond payments are fixed, thus uncertainty about the future predictability of returns is limited to defaults, which is marginal compared to equity. Second, our aim is to investigate information asymmetries between management and the remaining owners. Third, we assume that the capital structure is defined in favor of the equityholders, due to incentives for managers to act on their behalf.
The research on market
Determinants of leverage
To investigate the effect of expected changes in capital structure (target leverage changes) on information asymmetries, we implement a two-stage equation model that simultaneously includes the determinants of leverage and liquidity.
Our first step is to use standard leverage regressions, as proposed by Titman and Wessels (1988), Rajan and Zingales (1995), and Shyam-Sunder and Myers (1999) (see also Eq. (2)). The fitted value of this regression is then used as the leverage target. In order to
Structural changes in capital structure
One might argue that our main results are driven by small but irrelevant changes in capital structure, and that small changes in leverage could occur unintentionally rather than by management mandate. For example, consider maturing bonds, for which follow-up financing is not arranged or is just not available due to market conditions. In this case, market leverage could be driven by small changes in equity prices rather than by clear management decisions. We therefore analyze solely firms that
Conclusion
In summary, this paper analyzes the impact of expected (targeted) capital structure decisions on information asymmetries, measured in equity liquidity. The link between capital structure and liquidity is based on the assumption that managers are a subset of informed traders. As liquidity is driven by information asymmetries it is a viable, although imperfect, proxy for moral hazard problems between managers and owners. Few researchers have shed light on this endogenous interdependence.
Our
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This paper is partially based on chapter four of the doctoral thesis of Timur Karabiber at WHU — Otto Beisheim School of Management.
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We are very grateful to an anonymous referee for many helpful comments and to editor Jeffry M. Netter for very useful suggestions. We would like to thank Yakov Amihud, Christian Koziol, Juliane Proelss and Lutz Johanning. All remaining errors are our own.
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