As said before, there are no formally developed theories of capital structure (Myers, 2001). But there are some conditional theories that tell us how managers determine their target capital structure. In this chapter I will start with an overview of the traditional theories; the propositions of Modigliani and Miller, the Trade-off theory and the Pecking order theory. In section 2.2 I will describe earlier literature on the effect of capital structure on corporate events.
2.1 Capital Structure Theories
2.1.1 Modigliani and Miller
2.1.1.1 Proposition I
Modigliani and Miller where the first to investigate a firm’s capital structure, in their first proposition they state that the total value of its outstanding securities do not change by changing the proportions of its capital structure (Ross, 2010). The value of a firm is measured by the rentability and risk on investment of this firm. This proposition is considered as the beginning point of modern corporate finance. It uses the assumption that individuals can borrow at the same price as corporations. If this counts, then it will be the case that if levered corporations are overpriced, rational investors will borrow on their personal accounts to buy shares in unlevered firms. The prices of levered corporations will decline, and the value will be the same as before.
2.1.1.2 Proposition II
Because levered firms have greater risk, it should have a greater return as compensation. This is what is stated in the second proposition of Modigliani and Miller (Miller, 1977). They state that the expected return is positively related to leverage because the risk to equity holders increases with leverage. This proposition indicates that managers cannot change the value of the firm by repackaging their firm’s securities. The overall cost of capital will not be reduced as equity is substituted for debt, because the equity will become riskier. The cost of equity will increase and this will offset the low cost of debt.
The propositions of Modigliani and Miller are pure theoretical, so it does not work this way in the real world.
2.1.1.3. Proposition III
In 1963 Modigliani and Miller add taxes in their model (Miller M. , 1963). This is because firms have to pay taxes over their revenues. This causes big changes, due to the fact of the deductibility of interest payments. This is the so-called tax shield. Because of the fact that the tax shield increases the amount of debt, the firm can raise its cash flow and thereby its value by substituting debt for equity (Ross, 2010).
Overall, it can be stated that this propositions are dated and not working in reality. But these propositions are still considered to be the starting point for studying corporate finance and capital structure. Because of this, I will not refer to these theories anymore during the thesis.
2.1.2 Trade-off theory
2.1.2.1 Static trade-off theory
Kraus and Litzenberger firstly introduced the static trade-off theory in 1973 (Kraus, 1976). This theory states that firms balance the tax benefits of debt against the costs of financial distress and bankruptcy costs to get to their optimal leverage ratio. Because of the tax shield, firms favour debt over equity.
Costs of financial distress and bankruptcy costs offset the tax shield. A higher debt ratio causes a higher probability of bankruptcy resulting in financial distress costs (Kent Baker, 2011). These costs can be divided in direct and indirect costs. Direct costs are legal fees, restructuring costs and credit costs. Indirect costs are consumer confidence, vendor confidence and loss of important employees. Other costs are agency costs. Managers gave an incentive to maximize the equity value instead of the firm value. This may cause over- or underinvestment by a firm and not reaching their optimal capital structure.
2.1.2.2 Dynamic trade-off theory
Fisher, Heinkel and Zechner introduced the dynamic trade-off theory (Fisher, 1989). The argued that previous models did not take changes in capital structure, in response to changes in asset values, into account by setting an optimal capital structure. Also transaction costs may influence the choice to issue debt or equity. They found that firms almost always deviate from their target capital structure and they only adjust their leverage when it goes out of bounds. If a firm earns profits, they often pay off their debt. They found that firms only change their leverage periodically. In their model, they take all of this into account. It results in a range of optimal capital structure, only if it gets to close to its boundaries, the manager will recapitalize.
2.1.3 Pecking order theory
The pecking order theory on financing, first proposed by Myers and Majluf, is based on asymmetric information between firm insiders and outsiders and the resulting adverse selection problem (Myers M. , 1984). They assume that firms will take all investment opportunities if a firm has much excess cash. If a firm does not have that much cash, it needs to skip some investment opportunities. But in contrast to the trade-off theory, this theory does not give an optimal capital structure (Kent Baker, 2011). This theory states that firms do not acquire debt to get closer to their optimal capital structure, but as a consequence of their funding needs, which their internal resources cannot cover. If this holds, a firm prefers acquiring debt to external equity (Serrasqueiro, 2011).
2.1.4 Free cash flow theory
Jensen has determined the free cash flow theory (Jensen, 1986). This theory states that the capital market can force firm to finance new capital with debt over equity, in order to reduce the free cash flow. He argues that debt reduces the agency costs of free cash flow by reducing the cash flow that can be spend by the top management. Because of information asymmetry between investors and managers, and the agency problem, managers need to be forced to work in line with the needs of the investor. By reducing the free cash flow available for managers, will force them to choose the best investment. Increasing debt financing will in that way cause increasing efficiency of the organisation that generates large cash flows. The free cash flow theory predicts that prices will rise if the payouts to shareholders increase by the change in capital structure and vise versa. This does not hold for firms with profitable investment projects that are unfunded.
In this theory, capital structure is not chosen by the managers. But exists because of the agency problem, to force managers to work in line with the managers. This theory is not used in further studies, so will not be used in this thesis.
2.2 Empirical Literature on capital structure and corporate events.
2.2.1 Ahmed Riahi-Belkaoui (1998)
In his book, Ahmed Riahi-Belkaoui studies the impact of restructuring and diversification on capital structure . By testing two hypotheses, he tried to explain changes in the debt/equity ratio. In his research, he used 62 firms that transferred into a Multidivisional form (M-form). He classified them into three groups, based on diversification; unrelated, related and vertical. He used a longitudinal design to capture the effect of implementation and years -1 till +1 were excluded to avoid confounding with events during the transition. To test the overall relationship between the organizational and capital structure, diversification strategy and capital structure, and the interactive effect of organizational structure and diversification strategy on capital structure, he used a covariance analysis. The effects on capital structure of those three variables were tested by a F-test. The results of these tests indicate that by implementation of the M-form, the debt/equity ratios increased significantly. Also the mean of the debt/equity ratio increased. The results did not gave significant result about the diversification strategy and the difference in debt/equity ratios.
With this study, there is evidence that implementation of the M-form can affect the capital structure of a firm.
2.2.2 Hovakimian, Opler and Titman (2001)
In their paper, Hovakimian, Opler and Titman studied if firms tend to move toward a larger debt ratio when they either raise new capital or retire or repurchase existing capital. In contrast with earlier studies, this study account for the fact that firms change, which may cause the target capital structure to change.
Their sample consists of firm level data from the 1997 S&P’s Compustat annual files, this is in total 39387 firms in the period 1979-1997. They excluded financial firms. The equity and debt issuance data are used from Compustat. The sample contains 11136 security issues and 7366 security repurchases.
To examine if firms have a target capital structure, they used a two-step estimation procedure. The first step is to estimate the target debt ratios by regressing debt ratios on many variables. To obtain the results from the regression, they did a Tobit regression with double censoring. Second, they used the predicted target debt ratio from this first stage regression as a proxy for the capital structure in the long run. This model is a Logit regression that predict a firm’s financing choice in a given year.
For the first stage, they needed to determine the determinants of target capital structure: mean operating income/assets; net operating loss carryforward; stock return; market-to-book ratio; R&D expenditures/sales; selling expenses/sales; firm size; tangible assets. The results from this stage are consistent with previous studies.
In the second stage, they constructed variables that measure the deviation from the target ratio estimated in the first stage: leverage deficit; difference between leverage after issuing debt or equity; proxies for possible impediments to a move toward the target capital structure and stock price.
The analysis reveals that smaller firms tend to raise external capital, firms that raise convertible debt tend to be the smallest. Equity issuers tend to be less profitable and preferred stock issuers tend to be overlevered. The results also suggest that financing choices might be affected by the per-share earnings and the book values of equity.
The multivariate analysis consists of two Logit regressions. The first regression compared firms that issued debt with those that issued equity. The second compared firms that repurchased with those that issued. The results of the multivariate analysis suggest that the static trade-off theory are important in the choice of security repurchasing, but marginally by issuing a security. It also suggests that financially distressed firms are less likely to reduce leverage. All in all, is can be concluded that the deficit is an important, but not dominant, factor affecting the choice of debt and equity.
Next, the authors examine whether firm characteristics affects the amount of capital they raise. Because the determinants may differ with size, the regressions are estimated separately for each firm type. The results imply that security issue sizes are not affected by the deficit and are determined exogenously by the financing need of the issuing firm. They also imply that the financing method should be examined separately from the choice of size of financing. Otherwise, it is possible to miss some effects.
All in all, the results suggest that firms often make financing and repurchase decisions that offset these earnings-driven changes in their capital structure. The tendency of firms to make financial choices that move them toward their target capital structure appears to be more important by choosing between repurchases and retirement than with issuances. And firm that experience large stock price increases are more likely to issue equity and retire debt.
2.2.3 Harford, Klasa and Walcott (2001)
Do firms have leverage targets, the question Harford, Klasa and Walcott tried to answer in their paper. They have examined how leverage deficit affects the way of financing an acquisition and if and how they adjust their capital structure after an acquisition, by examining how the capital structure changes in the years after the acquisition.
Their sample consists of 1188 takeovers in the period 1981-2000 from the Thompson SDC Mergers and Acquisitions Database, and firm data from Compustat and Center for Research and Security Prices. To be included in the sample, the target’s size relative to the bidder’s is at least 20%. Because of the fact that the authors also examined the method of payment, there had to be information about the method of payment in the takeover.
The leverage deficit is defined as the difference between actual leverage and predicted target leverage. To calculate this, they used a tobit regression model on the determinants of capital structure: future year operating income; prior year natural logarithm of sales; prior year net property, plant and equipment/total assets; prior year market-to-book assets; prior year research and development expenses/sales; prior year dummy variable for if a firm has no research and development expenses; prior year selling expenses/sales and Fima and French industry dummies. Because the long sample period, they chose for separate annual regressions.
Doing a multivariate analysis shows whether the pre-acquisition leverage deficit can explain the financing choices. Using a two-sided tobit model explain the fraction paid in cash. The results show that the deficit and actual leverage are positively correlated and that the deficit is negatively associated with the fraction paid in cash. So, when a firm is overlevered there is a lower probability that it will pay in cash.
After finding out that managers really behave as they have a target capital structure, they examine the relation between the change in leverage and the change in target leverage. This allows to examine te extent to which the deficit affect the method of payment. They used models that explain the change in market leverage around the acquisition. This model uses the change in target leverage and the leverage deficit. The results of this model show a positive association between changes in actual and target capital structure.
The authors were also interested in the evolution of leverage deficit in the five years after the acquisition. By using the period -5,5 with the acquisition as reference point is shows that cash bidders reverse 75% of the effect of the acquisition on their leverage. This is consistent with the target capital structure hypothesis.
Next, the authors tried to provide insights into what factors drive bidder to reverse the effect of the acquisition on their leverage. The results of the models they used, show that the higher the leverage deficit before the acquisition, the more the bidder reduces its leverage deficit with a acquisition. This indicates that overleveraged bidders pays cash.
All in all, the results are that in planning an acquisition, bidders give consideration to their target capital structure. Overleveraged firms tend to take on more debt by doing a large acquisition. And managers are more likely to engage in an acquisition that will increase the leverage, if their target debt ratio increased. After the acquisition, the positive leverage deficit is reduced in the next five years. They concluded that firms do have target capital structures and managers do take them into account.
2.2.4 DeAngelo, DeAngelo and Whited (2011)
DeAngelo, DeAngelo and Whited have estimated a dynamic capital structure, this model differs from others because it tends to take into account that firms most of the time differ from their target capital structure. They call this transitory debt. To take this into account, they use slow average speed of adjustment (SOA). This implies that firms do not reach their target capital structure right away, but reach it slowly over the years.
In this model, transitory debt and target capital structure are systematically related. The capital structure choices are made each period, but in the long run firms have target capital ratios. To choose the parameters, they used the simulated method of moments. This method chooses the parameters that set moments of artificial data simulated from the model as close as the corresponding real data: profit function; shock serial correlation; smooth and fixed physical adjustment costs; the agency costs parameter; two external equity cost parameters; ratio of the debt limit.
They define target capital structure as “the matching of debt and assets to which the firm would converge if it optimized its debt and assets divisions in the face of uncertainty”. By taking transitory debt into account, this paper gives a new insight on the trade-off theory. Testing their model, it replicates the industry leverage, and that it explains the capital structure of firms better than the other theories.
2.2.5 Lang, Ofek and Stulz (1995)
In their article, Lang, Ofek and Stulz studies the relation between leverage and firm growth. To examine this, they used regressions on the cash flow over a period of 20 years. Their sample consists of large industrial firms, which they define as firms with minimum sales of one billion each year. This because they expect the effect to be weaker for larger firms, small firms tend to differ from the aggregate economic growth, so it would be harder to generalize and the data is available. This results in a sample of 640 different firms.
They used three growth measures: capital expenditures minus depreciation divided by the book value of fixed assets; the growth rate of real capital expenditures and the growth rate of employment. First, they control for variables that may affect the growth measures. Second, the correlations between those variables are examined. These correlations tell that there is a strong negative correlation between leverage and growth, negatively with Tobin’s q and that Tobin’s q is positively correlated with growth. This results in the conclusion that there is a negative relation between leverage and future growth, this can come from the correlation between leverage and the control variables. Therefore, they used multivariate regressions, with White adjustment for heteroscedasticity. Looking at the regression, it shows a strong negative relation between book leverage and growth. Including industry effect does not change this relation.
All in all, they found a strong relation between leverage and growth but only for firms with a low Tobin’s q. This suggests that this effect affects those firms with bad investment opportunities.
2.2.6 Drobetz, Pensa and Wanzenried (2007)
In their paper, Drobetz, Pensa and Wanzenried investigate the determinants of a firms’ time varying capital structure with a sample of 706 European countries over the period of 1983-2002. They do this by using a dynamic capital structure framework with the determinants of capital structure. With this framework, they analyze the effect of firm-characteristics as well as macroeconomic factors.
In their model, the target capital structure is determined as a linear function of the determining factors of capital structure: tangibility of assets; firm size; the growth opportunities; profitability and non-debt tax shields. To reduce the bias, they estimate their model by controlling for fixed-effects by applying a first-difference transformation. Another problem they had, was the correlation between past and current values, this is why they used instrumental variables. These variables also account for the fact that delay may arise between the decision and the implementation of the adjustment.
As determinants for the speed of adjustment, they used three firm-specific factors: growth, size and deficit, and six macroeconomic factors: the short interest rate; the term spread of interest rates; the credit spread; TED spread; the run-up average dividend yield and stock market performance.
Before estimating the model, they first test the specification of the target debt ratio by running fixed effects regressions. But because of the fact that leverage is sticky, they included a dummy variable for each year to estimate a combined time and firm fixed effects regression model.
The results from the specification of the target debt ratio show that the tangibility of assets is always positively related with leverage. This is consistent with the trade-off theory. The same holds for size. There is a negative relation between profitability and leverage, with strengthen the pecking order theory. And a negative relation between non-debt tax shields and leverage, also consistent with the trade-off theory.
The results for the adjustment speed suggest that large firms, growing firms and firms with a large deficit adjust faster than other firms. Also the speed increases if the economic prospects are good. It shows that firms are reluctant to adjust their capital structure following periods of higher valuations and that large variation in market leverage ratios leads to faster adjustment in the book ratios the following period.
2.2.7 Faulkender, Flannery, Watson-Hankins and Smith (2012)
In this paper, the authors studied the effect of cash flows on the speed of adjustment towards target capital structure. They contribute to the literature on the speed of adjustment towards target capital structure because it was the first time it was stated that not only adjustment costs determined the speed of adjustment but also the available cash flow.
To determine the target capital structure, they used a partial adjustment model of capital structure. The regression following this model assumes that a firm’s adjustment starts from the leverage in the period before. But only active adjustments entail transaction costs and the model should only focus on these adjustments. Therefore, they revised the model by separating the active component from the model. Their data consists of firms covered in Compustat, excluding the financial firms and utilities. To determine leverage, they, in contrast to other studies, focus on the book value of leverage.
By estimating the regression models, they found that there is no difference between the adjustment speed for market- or book-valued leverage. If only using the active adjustments, the speed rises. This can be explained by the fact that the median firm is profitable and underlevered. When looking at the difference between benefit of adjusting to target capital structure between under- and overlevered firms, it shows that the effect is asymmetrical even if the adjustment costs are equal.
The third modification to the model makes sure that the model recognizes the cash flow that may affect the cost of making adjustments. This has two potential effects. First, the cash flow generates a possibility to adjust leverage at low cost. Second, if a firm confronts fixed costs by accessing the capital market, they are more likely to make leverage adjustments when part of the fixed costs is born by the need balance their cash flows. The results from the regression suggest that the adjustment speed is smaller when the costs are only offset by the benefits from reaching the target capital structure.
All in all, it can be concluded that adjustment costs are important by determining if the firm will adjust and the adjustment costs appear to have at least one variable component, because otherwise a firm will always adjust to its target.
Next, the authors examine how firm and financial market characteristics can affect adjustment speeds. To make this possible, they modify the model again by include a variable of interest. This variable contains financial constraint and market timing variables. The financial constraint variables result in the finding that larger firms adjust slower than smaller firms. This appears that larger firms enjoy lower benefit from reaching their target capital structure, for both under- and overleverd firms. The market timing variables result that a higher interest rate and higher equity valuations decrease the speed for underlevered firms. For overlevered firms, higher equity valuation appears to increase their speed. The effect of interest rate is limited for overlevered firms.
All in all, the results are consistent with the trade-off theory, if the benefits and costs are right, firms wish to reach their target capital structure.
2.2.9 Huang and Ritter (2009)
Huang and Ritter present in their paper empirical evidence for the static trade-off, pecking order and market timing theory. They study how a firms’ financing behavior is affected by the market conditions. For this study, they used firms from the period 1963 to 2001, excluding the utilities, financial and small firms.
First, they examine the market timing and securities issuance decisions. By using an annual OLS regression with the net debt issuance as the dependent variable, a pooled OLS regression linking the pecking order to the cost of capital and a pooled nested logit regression. The first regression results in the conclusion that firms finance their leverage deficit with external equity when the cost of equity is low. This is consistent with the market timing theory. It also shows that firms choose to finance their deficit with debt when the corporate tax rate is higher, which is consistent with the trade-off theory. It comes clear that the equity risk premium (ERP) is taken into account by the choice for debt or equity. The pooled nested logit regression results in first level that firms that have more cash and are profitable are less likely to access external capital. In second level, they examine the choice between debt or equity. The results tell that firms with more cash are more likely to issue equity and profitable firms are more likely to issue debt. It also shows that, consistent with the trade-off theory, high leverage firms are more likely to issue equity rather than debt.
To examine the effects of market timing on capital structure, they estimate a regression with the leverage ratio as the dependent variable. The pooled OLS regression suggests that the financing deficit results in a smaller increase in book leverage when the cost of equity is low. This is inconsistent with the pecking order theory.
By using a dynamic panel model, Huang and Ritter studied the speed of adjustment to the target leverage. By using a large model, it is possible to evaluate the sensitivity of the adjustment speed to the time dimension. To avoid the short time bias, they did a pooled OLS ignoring the firm fixed effects, a mean differencing and a long differencing estimator. The pooled OLS showed that the speed is biased downwards, the mean differencing showed that it is biased upwards. This is why they choose for the long differencing estimator. The results suggest that firms tend to move toward the target capital structure, but at a moderate pace.
All in all, this paper shows that both the market timing theory and the static trade-off theory are important by determining the capital structure.
2.2.10 Titman and Wessels (1988)
This study from Titman and Wessels tried to extend the empirical work on capital structure in three ways. First, it examined some of theories that had not been analysed in 1988. Second, they analysed different types of debt and third, they used a linear structural model which gave other insights then had been given before.
The linear structural model assumes that it is possible to observe some variables that are linear functions of some attributes and the random error. They used the variables: collateral value of assets; non-debt tax shield; growth; uniqueness; industry classification; size; volatility and profitability to analyse if they really affect the capital structure choice. Their sample consist of 469 firms with data from the period 1974-1982. This period was divided in three subperiods over which the variables were averaged, by doing this it reduced the measurement error due to fluctuations.
Leverage is defined in six different ways, long-term, short-term and convertible debt divided by market and by book values of equity. This is because some of the theories on capital structure have other implications on leverage and how debt ratios are measured. This does not mean that there cannot be any spurious correlation. The dependent variable can still be correlated with the explanatory variables.
They used the model developed by Jöreskog and Sörbom (1981), this is a factor-analytic model which consists of two parts: a measurement model and a structural model. In the measurement model, firm-specific attributes are measured by relating them to observable variables. In the structural model, the measured debt ratios are specified as functions of the variables from the measurement model.
Their results suggest that firms with unique products have low debt ratios and that smaller firms tend to use more short-term debt.
The results from this model suggest that small firms tend to use more short-term debt, this can be explained by the high transaction costs involved. Small firms might not have the possibility to pay these. Also firm with high market-to-book values have higher borrowing capacities and hence higher debt levels. This indicates that many firms are guided by their market values when selecting their debt levels.
2.2.11 Uysal (2010)
As said before, this thesis is inspired by the paper of Uysal. Uysal investigates if managers do take their target capital structures into account when planning and structuring acquisitions. In this paper, he used firms covered in Compustat in the period 1990-2007, excluded financial firms and utilities. He also dropped firms with sales less than 10 million dollars. He estimated the target capital structure with the data of 52642 firms. Of these firms he obtained the completed domestic acquisitions covered in Thompson SDC Mergers and Acquisitions Database. He dropped acquisitions with a ratio of transaction value to total assets of the acquirer is less than 1%. This sample consists of 7814 acquisitions.
He used a two-step estimation procedure, like the one described by Hovakimian, Opler and Titman. In the first step, he estimated the target leverage ratio by running annual regressions of the leverage ratios on the main determinants of capital structure. The fitted value is defined as the target capital structure.
In the second step, he performed regressions that studies if the deficit affects the choice of making an acquisition, and the method of payment. To test whether the deficit affects the premium paid, het include the variable acquisition premium. To capture the effect of size, he included the natural logarithm of sales. As proxies for growth, he used market-to-book ratio and stock return. He also included the ratio of selling expenses to sales and the ratio of R&D to total assets.
The regression indicates different acquisition choices for under- and overlevered firms. This finding implies that firm size and stock price are less like to capture the effect over overleverage on acquisition choices.
To estimate the likelihood of making an acquisition, he used a Probit analysis. Ro estimate the ratio of the sum of acquisition value to total assets, he used a Tobit analysis because the dependent variable is censored at zero. Both analyses result in significant effect of deficit on the likelihood of making an acquisition. When looking at the symmetry between over- and underlevered firms, it is concluded that the effect is significant for overlevered firms, not for underlevered firms. This indicates that the effect of deficit on the likelihood is mainly driven by overleveraged firms.
To examine if the deficit affects the method of payment, Uysal used the previous Probit analysis, included market-to-book and stock return. These results indicate that the deficit affects the payment method. Leverage decreases the percentage of cash used in a deal.
By including Acquisition premium in the regression, it can be examined whether the leverage deficit affects the premium paid. As second proxy for the premium, he included the target cumulative abnormal return over the period of 20 days before the announcement. The regression indicates that overleveraged firms pay lower premiums and that managers take their deficit into account by structuring their acquisition.
Next, he examined whether leverage adjustments and equity issuance decision are taken into account by managers if they expect to make an acquisition. He included two dummy variables, overleveraged and underlevered and three proxies for the probability for undertaking an acquisition. First, the likelihood of making an acquisition. Second,