Corporate Finance Capital structure by Yanzhi Wang 1

Very early papers Trade-off theory In perfect and efficient markets, capital structure is irrelevant. (Modigliani and Miller(1958)) The trade-off theory determines an optimal capital structure by adding various imperfections. Including Taxes :(modigliani and miller(1963) Miller and Scholes(1978) Defngelo and masulis(1980)) Financial distress cost: Myers(1977) Agency costs: Jensen(1986) Fama and Miller(1972) Harris and Raviv(1991)

Shyam-Sunder and Myers (1999) Summary: This paper tests traditional capital structure models against the alternative of a pecking order model of corporate financing. This paper checks the statistical power of their tests against alternative hypotheses. We find that a simple pecking order model explains much more of the time-series variance in actual debt ratios than a target adjustment model based on the static tradeoff theory. Moreover, we show that the pecking order hypothesis can be rejected if actual financing follows the target- adjustment specification. On the other hand, this specification of the static tradeoff hypothesis will appear to work when financing follows the pecking order. 3

Static tradeoff theory It assumes an optimal capital structure of a firm. A value-maximizing firm would equate benefit and cost at the margin, and operate at the top of the value curve. 4 The curve would top out at relatively high debt ratios for safe, profitable firms with plenty of taxes to shield and assets whose values would escape serious damage in financial distress.

Static tradeoff theory- Empirical finding Schwartz and Aronson (1967), have documented evidence of strong industry effects in debt ratios, which they interpret as evidence of optimal ratios. Long and Malitz (1985) show that leverage ratios are negatively related to research and development expenditures, which they use as a proxy for intangible assets. Taggart (1977), Marsh (1982), Auerbach (1985), Jalilvand and Harris (1984) and Opler and Titman (1994) find mean reversion in debt ratios or evidence that firms appear to adjust toward debt targets. 5

Pecking order theory By Myers and Majluf (1984) In the pecking order theory, there is no well-defined optimal debt ratio. The attraction of interest tax shields and the threat of financial distress are assumed second-order. Debt ratios change when there is an imbalance of internal cash flow, net of dividends, and real investment opportunities. Highly profitable firms with limited investment opportunities work down to low debt ratios. Firms whose investment opportunities exceed internally generated funds borrow more and more. Changes in debt ratios are driven by the need for external funds, not by any attempt to reach an optimal capital structure. 6

Pecking order theory- Empirical finding Myers (1984) argues that the negative valuation effects of equity issues or leverage-reducing exchange offers do not support the tradeoff story. That is, if changes in debt ratios are movements towards the top of the curve (as in Fig. 1), both increases and decreases in leverage should be value enhancing, and there should be NO negative valuation effect. Kester (1986), Titman and Wessels (1988) and Rajan and Zingales (1995) find strong negative relationships between debt ratios and past profitability. (Remember! STT predicts positive relationship in this profitability test) 7

Pecking order model Funds flow deficit is where The pecking order hypothesis to be tested is: 8

Pecking order model If DEF is negative (by firm i). We expect a=0 and b PO =1. The pecking order coefficient is b PO. This is the simplest version of the pecking order (as expressed in above equation) but cannot be generally correct. It may, however, be a good description of financing over a wide range of moderate debt ratios. 9

Static tradeoff model The simple form of the target adjustment model states that changes in the debt ratio are explained by deviations of the current ratio from the target. The regression specification is: where D * it is the target debt level for firm i at time t. We take b TA, the target-adjustment coefficient. The target D * is generally unobservable. What should we do? 10

Data and sample selection Sample includes all firms on the Industrial Compustat files. Financial firms and regulated utilities were excluded. The sample period overs 1971-1989 because Compustat includes flow of funds statements from 1971. The requirement for continuous data on flow of funds restricts our sample to 157 firms. 11

Regression results for target adjustment and pecking order models Coefficients of TA and BO are all consistent with the predictions. R-sq of pecking order model is much higher 12

Test of power Statistical power is often investigated using Monte Carlo simulation on hypothetical data. In this case we start with the actual investment outlays and operating results of our sample companies. We then generate hypothetical time series of debt issues or retirements, one series for each of the 157 sample companies, using either the target adjustment model, Eq. (3), or the pecking order model, Eq. (2). 13

Test of power Actual data indicates what they found in previous table 14

Test of power Pecking specification rejects pecking order theory when using simulated target adjustment series. Target-adjustment specification fits the simulated pecking order series just as well as the actual data! This is clearly a false positive. 15

Frank and Goyal (2003) Summary: This paper tests the pecking order theory. Contrary to the pecking order theory, net equity issues track the financing deficit more closely than do net debt issues. Financing deficit is less important in explaining net debt issues over time for firms of all sizes. 16

Tests on capital structure theories Rajan and Zingales (1995) use a different information set and international data to account for corporate leverage. Shyam-Sunder and Myers (1999) find strong support for this prediction in a sample of 157 firms that had traded continuously over the period 1971 to 1989. Yet, 157 firms is a relatively small sample from the set of all publicly traded US firms. Frank and Goyal (2003) study the extent to which the pecking order theory of capital structure provides a satisfactory account of the financing behavior of publicly traded US firms over the 1971 to 1998 period. 17

Three tasks First, the paper provides evidence about the broad patterns of financing activity, which include checks on the significance of external finance (bond and equity issues). Second, the paper examines a number of implications of the pecking order in the context of Shyam-Sunder and Myers (1999) regression tests. Finally, the paper examines whether the pecking order theory receives greater support among firms with severe adverse selection problems. Small high-growth firms are often thought of as firms with large information asymmetries. 18

Pecking order model We can use the flow of funds data to provide a partially aggregated form of the accounting cash flow identity as: Shyam-Sunder and Myers (1999) setting: Shyam-Sunder and Myers (1999) include the current portion of long-term debt (R t ) as part of the financing deficit beyond its role in the change in working capital. This paper reports only the results for which the current portion of long-term debt is not included as a separate component of the financing deficit. This choice favors the pecking order, but it does not affect the conclusions. 19

Pecking order model Changes in cash are included in changes in net working capital ( W). Changes in cash could be correlated with the amount of debt issued. This could arise in the presence of debt and equity issues, with excess proceeds parked for some period of time in excess cash balances. Inclusion of cash favors the pecking order theory. The pecking order theory treats the financing deficit as exogenous. The financing deficit includes investment and dividends, which are probably endogenously determined. 20

Disaggregation of the financing deficit Consider the following specification: A unit increase in any of the components of DEF it must have the same unit impact on D it, i.e., 21

Other information on leverage To test the pecking order, the paper considers tangibility, M/B, sales and profitability as key conventional variables. Firms with few tangible assets would have greater asymmetric information problems. Thus, firms with few tangible assets will tend to accumulate more debt over time and become more highly levered. However, tangibility is negatively related to the lower distress cost, in a way few tangible assets lead to less debt. Firms with high market-to-book ratios are often thought to have more future growth opportunities. Debt could limit a firms ability to seize such opportunities when they appear. 22

Other information on leverage Large firms are usually more diversified, have better reputations in debt markets, and face lower information costs when borrowing. The predictions on profitability are ambiguous. The tradeoff theory predicts that profitable firms should be more highly levered to offset corporate taxes. Yet profitable firms have more internet capital, so debt should be lowered. What sign of coefficient is expected? 23

Deficit, issuance of debt and equity Which one correlates deficit? 24

Pecking order test What does gap mean here? Does the table result support POT? 25

Pecking order test Disaggregation of the financing deficit 26

Other information on leverage 27

Baker and Wurgler (2002) Firms usually issue equity when their market values are high, relative to book and past market values, and repurchase equity when their market values are low. This paper documents that the resulting effects on capital structure are very persistent. As a consequence, current capital structure is strongly related to historical market values. The results suggest the theory that capital structure is the cumulative outcome of past attempts to time the equity market. 28

Introduction Pecking order theory Static version Myers and Majluf(1984) predicts that managers will follow a pecking order, using up internal funds first, then using up risky debt, and finally resorting to equity. Dynamic version Myers(1984) suggests that High growth firms reduce leverage in order to avoid raising equity as investment opportunities arise in the future.

Introduction Managerial entrenchment theory Zwiebel(1996) suggests that high valuations and good investment opportunities facilitate equity finance, but at the same time allow managers to become entrenched. They may refuse to raise debt to rebalance in later periods.

Introduction Market timing phenomenon Equity market timing refer to the practice of issuing shares at high prices and repurchasing at low prices. Firm issue equity when the cost of equity is relatively low and repurchase equity when the cost is relatively high. Firms tend to issue equity at times when investors are rather to enthusiastic about earnings prospects Managers admit to market timing in anonymous surveys. (Graham and harvey(2001)).

Variable definitions Book equity as total assets less total liabilities and preferred stock plus deferred taxes and convertible debt. Market equity is defined as common shares outstanding times price. Market leverage as book debt divided by the result of total assets minus book equity plus market equity. (e/A) as the change in book equity minus the change in balance sheet retained earnings divided by assets ( RE/A) as the change in retained earnings divided by assets (d/A) as the residual change in assets divided by assets.

Recent calendar trends in this sample include a decrease in market leverage, an increase in equity issues, and a decrease in internal finance. The concurrent increase in equity issues is suggestive of market timing.

Market-to-book and market timing Using three other variables that Rajan and Zingales(1995) find to be correlated to leverage in several developed countries. Market-to-book is defined as assets minus book equity plus market equity all divided by assets. Asset tangibility is defined as net plant, property, and equipment divided by total assets Profitability is defined as earnings before interest, taxes, and depreciation divided by total assets. Size is measured as the log of net sales.

External finance weighted average Market timing could be just a local opportunism whose effect is quickly rebalance to some target leverage ratio Market timing may have persistent effects, and historical valuations will help to explain why leverage ratios differ: external finance weighted-average The variable takes high values for firms that raised external finance when the market-to-book ratio was high and vice-versa.

Controlling for current investment opportunities in the form of current market-to- book leaves the past within-firm variation to do a better job of picking up. M/B efwa is the residual influence of past, within- firm variation in market-to-book.

Alta (2006) This paper examines the capital structure implications of market timing, and isolates timing attempts in the initial public offering. This paper finds that compared with cold-market IPOs, hot-market IPO firms issue substantially more equity, and lower their leverage ratios. However, immediately after going public, hot- market firms increase their leverage ratios by issuing more debt and less equity relative to cold- market firms. At the end of the second year following the IPO, the impact of market timing on leverage completely vanishes. 41

Long-term impact of market timing on capital structure Baker and Wurgler (2002) find persistent timing effects on leverage that extend beyond 10 years. The market-to-book ratio is likely to proxy for underlying firm characteristics (most notably the long-term growth), a spurious relation between history and capital structure may obtain. More growth opportunities lead to more needs which are recorded in the history, market-to-book ratio is higher for high growth stocks. This is less relevant to the market timing. 42

IPO and capital structure This paper focuses on a single financing event, the initial public offering, in an attempt to capture market timing and its impact on capital structure. Investors face more uncertainty and a higher degree of asymmetric information when valuing IPO firms than they face in the case of mature public companies. Hence, IPOs offer more room for misvaluation. Market timing attempt is most apparent in the IPO market. IPO sample is likely to be highly revealing of pure market timing motives that are distinct from long- range financing policy requirements. 43

Main market timing measure My measure of market timing is direct and very simple: whether the IPO takes place in a hot issue market, characterized by high IPO volume in terms of the number of issuers, or a cold issue market If issuers regard hot markets as windows of opportunity with a temporarily low cost of equity capital, they should react by issuing more equity than they would otherwise do. Conversely, cold-market IPOs are likely to keep their equity issues to a necessary minimum, as market conditions are less favorable than average. Quantifying market timing attempts this way has the advantage of not picking up firm-level characteristics; the timing measure is instead a function of market conditions. 44

Data and sample selection The initial sample consists of all IPOs between January 1, 1971, and December 31, 1999, reported by the Securities Data Company (SDC). The sample excludes spinoffs, unit offers, financial firms with SIC codes between 6000 and 6999, and firms with book values of assets below $10 million in 1999 dollars at the end of the IPO year. This paper further restricts the sample to those firms for which COMPUSTAT data are available for the last fiscal year before the IPO. 45

Variable definitions Book debt, D, is defined as total liabilities (COMPUSTAT Annual Item 181) and preferred stock (Item 10) minus deferred taxes (Item 35) and convertible debt (Item 79). Book equity, E, is total assets (Item 6) minus book debt. Book leverage, D/A, is then defined as book debt divided by total assets. Market-to-book ratio, M/B, is book debt plus market equity (common shares outstanding (Item 25) times share price (Item 199)) divided by total assets. As in Baker and Wurgler (2002), I drop observations for which M/B exceeds 10.0. Net debt issues, d/A, is the change in book debt. Net equity issues, e/A, is the change in book equity minus the change in retained earnings (Item 36). Newly retained earnings, RE/A, is the change in retained earnings. Profitability is measured by EBITDA/A, which is earnings before interest, taxes, and depreciation (Item 13). SIZE is the logarithm of net sales (Item 12) in millions of 1999 dollars. 46

Hot and Cold Markets Hot (cold) months are then defined as those that are above (below) the median in the distribution of the detrended monthly moving average IPO volume across all the months in the sample. 47

Market timing effects on issuance activity 48

Alternative explanations Hot-market firms could issue more equity than their cold-market counterparts for reasons other than market timing. Hot-market firms may be severely overleveraged before going public, and may attempt to revert back to their leverage targets at the IPO. Another potential explanation for the equity issue activity of hot-market firms is that they grow faster. If hot-market firms invest at higher rates, or expect to do so in the near future, then they are likely to finance part of this growth by raising equity capital. 49

Test on alternative explanations 50

Dividend payout of IPOs Further evidence of market timing comes from the dividends hot-market firms pay in the IPO year. Issuers view hot markets as windows of opportunity for selling equity relatively easily, and hence feel confident to proceed with an offering whose proceeds will largely finance a special dividend. 51

Short-term and long-term impacts of market timing on capital structure 52

Welch (2004) U.S. corporations do not issue and repurchase debt and equity to counteract the mechanistic effects of stock returns on their debt equity ratios. Stock returns can explain about 40 percent of debt ratio dynamics. Although corporate net issuing activity is lively and although it can explain 60 percent of debt ratio dynamics (long term debt issuing activity being most capital structurerelevant), corporate issuing motives remain largely a mystery. 53

Capital structure ratios Actual corporate debt ratio (ADR) is defined as the book value of debt (D) divided by the book value of debt plus the market value of equity (E), and we set basic specification estimate as The term IDR is the implied debt ratio that comes about if the corporation issues (net) neither debt nor equity, where x is the stock return net of dividends. The amount of debt changes with new debt issues, debt retirements, coupon payments, and debt value changes. 54

Hypothesis Perfect readjustment hypothesis: 1 =1, 2 =0. Perfect nonreadjustment hypothesis: 1 =0, 2 =1. Corporate debt evolves as where is the total debt net issuing activity. Equivalently, the amount of corporate equity changes with stock returns (net of dividends) and new equity issues net of equity repurchases. 55

Hypothesis Corporate equity evolves as where ENI is net equity issuing and stock repurchasing activity. With these definitions, debt ratios evolve as 56

Hypothesis Mathematically, if the corporation issues debt and equity so that then ADR remains perfectly constant across periods (ADR t+k =ADR t => 1 =1, 2 =0). In contrast, if the corporation issues debt and equity so that then IDR perfectly predicts debt ratios (IDR t,t+k =ADR t => 1 =0, 2 =1) 57

A dependent sort Welch sorts all firms by stock return controlled for size of firms as follows. All firms are first sorted by year and then by sales and, within each consecutive set of 10 (similarly sized) firms, allocated into 10 bins on the basis of their S&P net stock return performance. This procedure keeps a roughly equal number of firms in each decile and maximizes the spread in stock returns across decile, holding calendar year and firm size constant. Questions: what difference between dependent and independent sorts would be ? 58

Corporate Activity, Equity Growth, and Capital Structure, Classified by Stock Returns 59

Over one year, firms respond to poor performance with more debt issuing activity and to good performance with more equity issuing activity. This hints that firms do not immediately readjust: firms whose debt ratios increase (decrease) because of poor (good) stock return performance seem to use their issuing activities not to readjust but to amplify the stock return changes (same as Baker and Wurgler, 2002) The fourth row shows that the relationship between stock returns and activist equity expansion is more U shaped when dividends are considered. 60

Fama-MacBeth (1973) regression The reported coefficients (in %) and standard errors are computed from the time series of cross sectional regression coefficients (called Fama MacBeth) 61

Regression using change in ADR 62

Regression using change in ADR The regression can also be estimated in changes or with a restriction that the coefficients on IDR and ADR add up to one: After rearrangement, the estimated regressions are Thus stock returncaused equity growth can explain about 40 percent of capital structure dynamics All corporate issuing activity together can explain about 6070 percent. 63

Frank and Goyal (2009) This paper examines the relative importance of many factors in the capital structure decisions of publicly traded American firms from 1950 to 2003. The most reliable factors for explaining market leverage are: Median industry leverage (+ effect on leverage), Market-to-book assets ratio ( ), Tangibility (+), Profits ( ), Log of assets (+), Expected inflation (+). When considering book leverage, somewhat similar effects are found but some become weaker. The empirical evidence seems reasonably consistent with some versions of the trade-off theory of capital structure. 64

Capital structure theories Many theories of capital structure have been proposed. But only a few seem to have many advocates. Notably, most corporate finance textbooks point to the trade-off theory in which taxation and deadweight bankruptcy costs are key. Myers (1984) proposed the pecking order theory in which there is a financing hierarchy of retained earnings, debt, and then equity. The idea that firms engage in market timing has become popular. Finally, agency theory lurks in the background of much theoretical discussion. Agency concerns are often lumped into the trade-off framework broadly interpreted. 65

Measures of leverage Book leverage Book leverage is also preferred because financial markets fluctuate a great deal and managers are said to believe that market leverage numbers are unreliable as a guide to corporate financial policy. Market leverage Book value of equity is primarily a plug number used to balance the left-hand side and the right-hand side of the balance sheet rather than a managerially relevant number. Book value of equity can even be negative. The book measure is backward looking and markets are generally assumed to be forward looking. 66

Predictions of leverage factors Profitability Firm size Growth opportunity - Industry conditions Tangibility Tax Risk - Supply-side factors Stock and debt market conditions Macroeconomic Conditions How can we measure those variables? What are predictions? See pages 7-11 for a thorough discussion. 67

What is the firm-year for 1950-2003? What are average level of leverage? What differs among leverage measures? How do they deal with outliers? 68

Regression results 69

Lemmon, Roberts and Zender (2008) We find that the majority of variation in leverage ratios is driven by an unobserved time-invariant effect that generates surprisingly stable capital structures: High (low) levered firms tend to remain as such for over two decades. This feature of leverage is largely unexplained by previously identified determinants, is robust to firm exit, and is present prior to the IPO, suggesting that variation in capital structures is primarily determined by factors that remain stable for long periods of time. 72

How do we know the capital structure of a firm? Finance studies identify a number of factors that purport to explain variation in corporate capital structures. However, after decades of research, how much do we really know? The adjusted R-squares from traditional leverage regressions using previously identified determinants range from 18% to 29%. In contrast, the adjusted R-square from a regression of leverage on firm fixed effects is 60%, implying that the majority of variation in leverage in a panel of firms is time invariant and is largely unexplained by previously identified determinants. One possible explanation for these findings is that commonly employed empirical models are misspecified because managers are more concerned with variation in long-run or equilibrium levels of leverage determinants, as opposed to short-run fluctuations. 73

Regression anlalysis 75

Cohn, Mills and Towery (2014) This study uses corporate tax return data to examine the evolution of firms' financial structure and performance after leveraged buyouts (LBOs) for a comprehensive sample of 317 LBOs taking place between 1995 and 2007. It is found that little evidence of operating improvements subsequent to an LBO, although consistent with prior studies, we do observe operating improvements in the set of LBO firms that have public financial statements. They also find that firms do not reduce leverage after LBOs, even if they generate excess cash flow. 76

Leveraged buyout A leveraged buyout (LBO) is when a company is purchased with a combination of equity and significant amounts of borrowed money, structured in such a way that the target's cash flows or assets are used as the collateral (or "leverage") to secure and repay the money borrowed to purchase the target-company/asset. Private equity acquirers took almost 3% of the U.S. stock market (by market capitalization) private in LBOs in 2006. LBO is closely related to issues regarding M&A and corporate control. 77

Leveraged buyout Most LBOs go private and have no public financial data. This paper overcomes the lack of public financial data by instead relying on confidential federal corporate tax return data. Because all U.S. corporations must file tax returns. Their primary sample consists of 317 previously publicly traded firms acquired in LBOs between 1995 and 2007 with assets of at least $10 million. This represents approximately 90% of LBO firms of this size during this period. 78

LBO sample 79 This paper collects LBOs between 1995 and 2007 of publicly traded, stand-alone firms using Dealogic's Mergers & Acquisitions database and Thomson Financial's Securities Data Corporation (SDC) Platinum mergers database.

Operating performance Levels of ROS Results are similar with ROA, 80

Changes in operating performance We do observe statistically significant positive median changes in industry- and performance level-adjusted (though not propensity- adjusted) PreInterestROS over most time horizons, but the magnitudes of these increases are relatively small (less than 2% inallcases). 81

Results with public data Operating improves in the set of LBO firms that have public financial statements. 82

Capital structure of LBOs Firms do not reduce leverage after LBOs, even if they generate excess cash flow. 83

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Corporate Finance Capital structure by Yanzhi Wang 1