Full text available at: [Link]

1561/0500000018

Empirical Capital
Structure: A Review
Full text available at: [Link]

Empirical Capital
Structure: A Review

Christopher Parsons

University of North Carolina at Chapel Hill

USA
Chris Parsons@[Link]

Sheridan Titman

University of Texas at Austin

USA
[Link]@[Link]

Boston – Delft
 Full text available at: [Link]

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Foundations and Trends R in

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Vol. 3, No. 1 (2008) 1–93
c 2009 C. Parsons and S. Titman
DOI: 10.1561/0500000018

Empirical Capital Structure: A Review

Christopher Parsons1 and Sheridan Titman2

1
University of North Carolina at Chapel Hill, USA,
Chris Parsons@[Link]
2
University of Texas at Austin, USA,
[Link]@[Link]

Abstract
This survey provides a synthesis of the empirical capital structure liter-
ature. Our synthesis is divided into three parts. The first part examines
the evidence that relates to the cross-sectional determinants of capital
structure. This literature identifies and discusses the characteristics
of firms that tend to be associated with different debt ratios. In the
second part, we review the literature that examines changes in capi-
tal structure. The papers in this literature explore factors that move
firms away from their target capital structures as well as the extent
to which future financing choices move firms back toward their tar-
gets. Finally, we complete our review with a set of studies that explore
the consequences of leverage, rather than its determinants. These stud-
ies are concerned with feedback from financing to real decisions. For
example, we explore how a firm’s financing choices influences its incen-
tive to invest in its workers, price its products, form relationships with
suppliers, or compete aggressively with competitors.
 Full text available at: [Link]

Contents

1 Introduction 1

2 Econometric and Specification Issues 5

3 The First Ingredient: Determinants of Target

Leverage 9
3.1 Tax Exposure 9
3.2 Cash Flow Volatility 14
3.3 Size 16
3.4 Asset Tangibility/Liquidity 18
3.5 Market-to-Book Ratio 21
3.6 Product Uniqueness 22
3.7 Industry Effects 23
3.8 Firm Fixed Effects 25
3.9 Quantifying Optimal Debt Ratios 26

4 The Second Ingredient: Deviations from Target

Leverage Ratios 29

4.1 Profitability 30
4.2 Market Timing 31
4.3 Stock Returns 35
4.4 Managerial Preferences and Entrenchment 36

ix
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5 Capital Structure Changes 43

5.1 The Choice of Debt vs Equity 44
5.2 Speed of Adjustment 48
5.3 Tests of Pecking Order Behavior 50

6 Stakeholders, Competitive Strategy, and

Investment 57
6.1 Debt and Investment 58
6.2 Debt and Workers 62
6.3 Debt and Customers 67
6.4 Debt and the Firm’s Suppliers 71
6.5 Debt and Competitors 73

7 Conclusion 83

References 87
 Full text available at: [Link]

1
Introduction

Corporations fund their operations by raising capital from a variety

of distinct sources. The mix between the various sources, generally
referred to as the firm’s capital structure, has attracted considerable
attention from both academics and practitioners. The empirical capital
structure literature explores both the cross-sectional determinants of
capital structure as well as time-series changes. This survey reviews
both aspects of this literature.
Our review is organized around a simple framework that contains
three key ingredients. The first is that at any point in time, there
are benefits and costs associated with various financing choices, and
that the trade-offs between these benefits and costs lead to well-defined
target debt ratios. The second is the existence of shocks that cause firms
to deviate, at least temporarily, from their targets. The third is the
presense of factors that prevent firms from immediately making capital
structure changes that offset the effect of the shocks that move them
away from their targets. Almost all of the papers we examine can be
conveniently classified as addressing one or more of these ingredients.
We begin our review with a group of studies that primarily deal
with the first ingredient, the costs and benefits that determine a firm’s

1
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2 Introduction

capital structure. These can include the tax benefit of debt, deadweight
costs of liquidation or reorganization, financial distress, and so on. The
studies we discuss here are mostly cross-sectional in nature, addressing
the extent to which firm characteristics, such as size and asset tangi-
bility, line up with observed capital structures in a way consistent with
theory. An implicit assumption of these cross-sectional studies is that
the observed debt ratios are relatively close to the firm’s actual targets.
That is, shocks that move debt ratios from their targets are generally
considered to be of second order importance in the interpretation of
these cross-sectional leverage regressions.
These shocks are the focus of the second group of studies we con-
sider. These studies focus explicitly on events in a firm’s life that
may cause it to be over- or under-leveraged relative to its target.
These shocks can include “market timing” opportunities (periods where
equity financing is temporarily cheap), periods of high (low) prof-
itability that allow the firm to passively accumulate (deplete) its cash
reserves, or rapid improvements in a firm’s prospects that substantially
change the value of a firm’s equity. Additionally, deviations from value-
maximizing targets can also stem from the firms’ management who may
realize private benefits from lower debt ratios. We discuss each of these
alternatives in detail, exploring both the cross-sectional and time-series
implications of such shocks.
Next, we move to the final ingredient — identifying factors that
may prevent firms from constantly maintaining debt ratios that match
their targets. To address this issue we first survey the empirical evi-
dence on capital structure changes. For example, studies of the timing
of the issuance of securities ask whether the debt vs equity issuance
choice is consistent with firms acting to move toward their debt ratio
targets. Then we turn to “speed of adjustment” models that exam-
ine how quickly firms move toward their targets. Such tests should be
thought of as a joint test of ingredients one and three. That is, if lever-
age shocks are not rapidly corrected, then there are two possibilities —
either target capital structures are not particularly important, or the
adjustment costs are simply too high to warrant an adjustment.
This latter case describes what has been referred to as “pecking
order” behavior, which is the subject of the next group of studies that
 Full text available at: [Link]

we consider. According to the pecking order described by Myers (1984)

and Myers and Majluf (1984), because of information asymmetries,
firms issue equity only as a last resort, funding investments first with
retained earnings followed by debt proceeds. Tests of the pecking order
are also time-series regressions, and are often run as a horse race against
standard speed of adjustment models.
To conclude our review, we examine a class of studies that consider
how a firm’s business decisions are influenced by how it is financed.
For example, how does a firm’s debt ratio influence how aggressively
it prices its products? Can firms with high leverage extract rents from
their workers, e.g., labor unions? Does leverage impede a firm’s ability
or willingness to invest? There are a number of studies in this literature
that consider this feedback from capital structure to business decisions,
and although these feedback channels have implications about the total
costs and benefits of debt, we segregate these studies from our discus-
sion of the target capital structure choice because the empirical issues
are very different. In particular, the direction/causality in these studies
run from the capital structure choice to the firm characteristic rather
than vice versa.
The review is organized as follows. In Section 2, we briefly discuss
some specification and econometric issues that will be important for
many of the tests we consider. Then, in Section 3 we begin our review
of cross-sectional capital structure determinants, focusing mostly on
costs and benefits involving the firm’s managers and suppliers of cap-
ital. Section 4 then explores factors that pull firms away from their
leverage targets. Then, in Section 5, we discuss reasons why firms might
not immediately reverse the effect of these leverage shocks, apparently
allowing deviations from their targets to persist for extended periods
of time. In Section 6, we explore a group of studies that looks at
the leverage problem from a different perspective. Rather than ask-
ing what determines leverage, these studies explore how leverage feeds
back into a firm’s real business decisions. Finally, Section 7 concludes
and provides suggestions for new research.
 Full text available at: [Link]

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