1

Capital Structure: taxes, financial distress, pecking order and the

role of the product market

Advanced Corporate Finance

Semester 1 2009

2

Capital structure and financing choices

Two observations• Leverage is persistent – low/high leverage firms tend to

maintain that level

• Cross-sectional variation in leverage is characterized by an important firm specific effect• R2 from a regression of leverage on firm fixed effects is around

60%

Explanations offered:• Target capital structure (trade-off theory)

• No target optimum (pecking order, market timing or price inertia)

3

Nice to Know You Don’t Matter By examining conditions that make financial decisions

irrelevant, we can learn when they will be relevant! Modigliani-Miller (M&M) propositions give these

conditions M&M propositions:

• M-M and the irrelevance of capital structure (Proposition I)

• M-M and the cost of capital (Proposition II)

• M-M and the irrelevance of distribution policy (Proposition III)

4

Assumption of MM

Frictionless capital markets No taxes

• corporate or personal No costs of bankruptcy No agency costs

• Management maximizes the value of the firm, regardless of capital structure.

What happens when we relax them?

Capital structure matters?

If MM’s assumptions are violated, then capital structure matters.

Usual violations• Traditional finance: bankruptcy costs, agency

problems, non-convex taxes, asymmetric information.

• Behavioral finance: inefficient markets, managerial and investor behavior.

If MM is violated, what is the “optimal” capital structure?

5

Trade-off theory I

This “theory” can be obtained from different perspectives.

Debt is “risky.”• Bankruptcy costs exist.

• There is a “tax-bankruptcy” trade-off for debt:• tax benefit

• bankruptcy cost.

6

Empirical evidence

Leverage increasing exchange offers increase firm value [Masulis (1980)]

Firms for which the tax benefit is highest use the most debt [Graham (1999)]

In US tax benefit of debt estimated to be 7% of firm value [Graham (2000)] but so are direct bankruptcy costs - for large companies 3.1% of total value on average [Weiss (1990)]

7

Tax changes

US Tax Reform Act of 1986 [Gordon & MacKie-Mason (1990)]• Aggregate capital structures changes consistent with Tax

Reform Act providing incentives to convert equity into debt

• Cross-sectional evidence consistent with tax induced capital structure changes around Tax Reform Act.

Dividend imputation of 1987 [Twite (2001)]• The aggregate level of debt in the corporate capital

structure has declined

• The higher the firm’s effective tax rate, the lower is the reduction in the proportion of debt in the firm’s capital structure

8

International transactions

Multinational are more levered than domestic corporations in Australia [Akhtar (2008)]

In US• Incentive to issue debt offshore as excess tax

credits increase [Newberry (1998)]

• Foreign debt placed in high tax domains [Desai (1997)]

9

Trade-off theory II

There is an “agency” perspective:• Debt disciplines manager and mitigates agency

problems of free cash flow, since debt must be repaid to avoid bankruptcy. But, exacerbates shareholder-debtholder conflicts.

• Here the costs of debt are from changes from “optimal” business operations• Jensen and Meckling (1976), Jensen (1986), and Hart

and Moore (1994)

10

Trade-off theory III

There is a “stakeholder co-investment” perspective:• Some firms efficiency requires a firm’s

stakeholders to make significant firm-specific investments. Firms making unique products will lose customers if they may go bankrupt.

• The costs of debt are from disruption to normal business operations that arise under financial distress• Titman (1984), Maksimovic & Titman (1991)

11

12

Balancing Story

Benefit Costs

PV tax PV of PV cost of PV lost PV

shield + inventive = financial + tax + agencycorporate effects distress shields costs ofand of debtPersonaldebtTaxes

Marginal benefit of debt declines are debt increases – there is an optimal capital structure

13

Capital structure and trade-off

Initial tests sought to regress leverage against proxies for costs and benefits [Titman & Wessels,1988; Rajan & Zingales, 1995]• Profit, Marginal tax rate, Earnings volatility (Z-score), Book-

to-Market, Capex, R&D

• Leverage is positively related to marginal tax rate, asset tangibility & firm size

• Leverage is negatively related to market-to-book ratio &non-debt tax shields

• But leverage is negatively related to profitability

Institutional structures matter

Leverage influenced by:• market (equity and bond) development

• institutional structures – preferences of suppliers of capital

• governmental and legal systems

• corporate governance regime

• tax regime Fan, Titman & Twite (2008)

14

Product market Debt induces unions to act less aggressively

• Bronars & Deere (1991)

Highly levered (transport) firms are less likely to survive deregulation than lower levered peers. Highly levered firms invest less aggressively and lower prices earlier• Zingales (1998)

Exogenous shock in leverage in grocery sector – oil prices. Competitor less (more) levered, LBOs lead decrease (increases) price, opportunistic predation by less financially constrained competitors (LBOs soften product market competition)• Chevalier (1995)

15

Testing Trade-off

Firms operate under a target D/E ratio, representing some “optimal D/E ratio.”

Firms do not instantaneously achieve their target D/E ratio.

They adjust the actual D/E ratio over time.• A dynamic trade-off model where the spped of

adjustment is a function of market frictions.

Dynamic trade-off model

where Di,t is firm i’s realized D/E in period t,

D*i,t is firm i’s target D/E ratio, Δ is the difference operator, γi is the partial adjustment coefficient (also called speed of adjustment); 0 ≤ γi ≤1, and ei,t is a regression error.

This model can be estimated using OLS.

17

tititiiti eDDD ,1,*,,

Target debt-equity ratio

But the target debt-equity ratio, D*i,t, is unobservable:it is not possible to directly test the dynamic trade-off model. Instead estimate the target D/E ratio:

where the vector Xi,t contains a variables that determine target capital structure

18

titi XD ,*,

Estimation

Estimation equation is in terms of observables.

Only (1-γi) will be estimated, γi cannot be recover from the unrestricted coefficient for Xi,t.

The speed of adjustment is estimated through the unrestricted coefficient of Di,t-1.

Estimate as panel or cross-section

19

,)1( 1,,, ittiitiiti eDXD

Evidence

Dynamic trade-off model dominates alternative models - firms adjust toward target debt-equity ratio at a moderate speed, with a half-life of 3.7 years (for book leverage).• Hovakimian, Opler, and Titman (2001), Flannery

and Rangan (2006), Kayhan and Titman (2007), Huang and Ritter (2008)

20

No optimum – pecking order Asymmetric information exists and it is costly.

Managers have more information about the quality of the firm.

Companies select financing according to:1. Internal financing (retained earnings)2. Bank debt3. Public debt4. Equity, last resort.

Donaldson (1961)

21

Pecking order

Adverse selection issues: Equity has a lot, debt a little, retained earnings none.• The choice of financing is a signal

Myers (1984): when equity is issued, investors think firm is overvalued (managers use the last resort tool, only because firm is overvalued). Investors demand a higher return on equity than on debt.

22

Empirical test: deficit model

Test the pecking order against the alternative of a static trade-off model. To generate the deficit model for the pecking order they use the flow of funds identity:

DEFt = DIVt + It + Wt - Ct = Dt + Et

Under pecking order, Et should be negligible and we can write:

Dit = a + bPODEFit + eit

If the pecking order holds strictly, a = 0 & bPO = 1

23

Empirical test: alternative model

Alternative is a simple target adjustment model:

Dit = a + bTA(D*it - Dit-1) + eit

Where D*it is the target debt level for firm i at

time t. The testable restriction in this case is 0<bTA <1 Both models hold but pecking order is more

strongly supported.• Higher R2

24

Joint test

Recognise that tests of the Pecking Order based on deficit model are tests of the joint hypothesis of ordering (the financial hierarchy) and proportions (equity issues constitute a low percentage of external financing).

25

Conditional model

Leary and Roberts (2007) test the pecking order on a conditional basis, controlling for:• Financing not directly related to investments.

• Differences in information asymmetry.

• Possible constraints from debt capacity. Only 33% of firms adhere to the pecking

order.

26

27

Capital Structure and pecking order

Firms prefer internal funds The more profitable the firm the lower its

debt/equity ratio Levered firms invest less

Remaining puzzles

Firms use debt financing too conservatively• Graham (2000), Strebulaev & Yang (2007).

Negative relation between profitability and leverage• Myers (1993), Myers and Shyam-Sunder (1999).

Leverage levels are persistent• Lemmon, Roberts, and Zender (2008)

28

Remaining puzzles Firms mean-revert slowly towards target

leverage• Fama and French (2002), Flannery and Rangan

(2006). Changes in market leverage are largely

explained by changes in equity prices• Welch (2004)]

Leverage largely driven by unexplained firm-specific fixed effect• Lemmon, Roberts, Zender (2006).

29