Finance Articles

326 The Journal of Finance

second, we briefly summarize the available empirical evidence. In the third, we compare the theoretical predictions with the evidence. Much of the material in this section is synthesized in tables. These tables are as follows:

. Table II: Summary of Theoretical Results . Table III: Industry Leverage Rankings * Table IV: Determinants of Leverage . Table V: Comparison of Theoretical and Empirical Results . Table VI: Other Empirical Results . Table VII: Summary of Results by Model Type

A. Summary of Theoretical Results

Those theoretical results that are potentially testable are summarized in Table II, consisting of four panels. Panel A contains implications regarding the relationship between leverage and exogenous factors that are not the result of decisions by agents in the model, e.g., profitability, characteristics of the product market, etc. Panel B contains implications regarding the rela- tionship between leverage and endogenous factors that are the result of decisions by agents in the model. In this case, both leverage and the other factor are jointly determined by some third, exogenous factor. Typically, in these cases the endogenous factors are more readily observable than the exogenous driving factor. In Panel C, we list results relating the flrm's stock price response to announcements of capital structure changes. Panel D contains other results that do not flt into the above three groups.38 In each panel, the first column contains the theoretical prediction; the second column indicates the type(s) of model(s) from which the result was derived and corresponds to the various sections of the survey; the third column provides the specific references for the result.

The table makes it clear that the literature provides a substantial number of implications. The other striking feature is that there are very few cases in which two or more theories have opposite implications (these are indicated by a shaded background). Such conflicts can provide sharp tests capable of rejecting one or more theories in favor of another. The only instances of conflicting results are: i) Chang (1987) predicts a negative relationship of leverage and firm profitability while several studies predict a positive rela- tionship (see Panel A); ii) Myers and Majluf (1984) predicts a negative relationship between leverage and free cash flow while Jensen (1986) and Stulz (1990) predict a positive relationship (see Panel A); iii) Stulz (1988) predicts a positive relationship between leverage and the takeover premium captured by a target while Israel (Forthcoming) predicts the opposite rela- tionship (see Panel B); iv) Myers and Majluf (1984) and related papers predict the absence of a stock price reaction to a debt issue announcement while numerous papers predict a positive reaction (see Panel C); and v) several papers argue against the pecking order theory of Myers and Majluf (1984)

38 Other theoretical results not directly relating to capital structure are not included in this summary even though they may be potentially testable.

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The Theory of Capital Structure 327

Table II

Summary of Theoretical Results

The table shows, for each theoretical result, the type of model from which the result was derived and the specific papers that obtain the result. Model types also refer to sections in the paper. The shaded cells (separated by dashed line) indicate

results that are in conflict.

Panel A. Association Between Leverage and Exogenous Factors

Leverage increases with: Model References

Exen of f 'ormation asymmetry Asymmetric Info. Myers & Majluf (1984)

Increases in pfialtyAsymmetric Info. Ross (1977), Leland & Pyle (1977), Heinkel

(1982), Blazenko (1987), John (1987), Poitevin

(1989), Ravid & Sanig (1989)

Dera i ia bi Agency Chang (1987)

Extent of strategic interaction in the Product/Input Markets Brander & Lewis (1986)

product market

Elasticity of demand for the product Product/Input Markets Maksimovic (1988)

Extent to which product is'not unique and Product/Input Markets Titman (1984)

does not require specialized service

Extent to which reputation for product Product/Input Markets Maksimovic & Titman (Forthcoming)

quality is unimportant

Extent to which workers are unionized or Product/Input Markets Sanig (1988)

have transferable skills

Extent to which the firm is a takeover Control Harris & Raviv (1988), Stulz (1988), Israel

target or lack of anti-takeover measures (Forthcoming)

Agency Stulz (1990), Hirshleifer & Thakor (1989)

Potential gains to takeover and reductions Control Israel (Forthcoming)

in their costs

Fraction of cash flow that is unobservable Agency Chang (1987)

Lack of growth opportunities, extent of Agency Jensen & Meckling (1976), Stulz (1990)

regulation

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328 The Journal of Finance

Table II-(Continued)

Panel A. Association Between Leverage and Exogenous Factors

Leverage Increeases with: Model References Increases in free cash flow Agency Jensen (1986), Stulz (1990)

DeCreases hn free cash flow Asymmetric Info. Myers & Majluf (1984)

Increases in liquidation value Agency Williamson (1988), Harris & Raviv (1990a)

Decreases in investigation costs Agency Harris & Raviv (1990a)

Increases in the importance of managerial Agency Hirshleifer & Thakor (1989)

reputation

Panel B. Association Between Leverage and Endogenous Factors

Result Model References

Leverage is positively correlated with Agency Harris & Raviv (1990a), Stulz firm value (1990), Hirshleifer & Thakor

(1989)

Asymmetric Info. Ross (1977), Noe (1988), Narayanan

(1988), Poitevin (1989)

Control Harris & Raviv (1988), Stulz (1988),

Israel (Forthcoming)

Leverage is positively correlated with Agency Harris & Raviv (199Oa)

default probability Asymmetric Info. Ross (1977)

Leverage is positively correlated with Asymmetric Info. Leland & Pyle (1977)

the extent of managerial equity ownership Control Harris & Raviv (1988), Stulz (1988)

Leverage is positively correlated with Control Stulz (1988)

target premium

Leverage is negatively correlated with Control Israel (Forthcoming)

target premium

Leverage is negatively correlated with Control Stulz (1988)

probability of successful takeover

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The Theory of Capital Structure 329

Table II-(Continued)

Panel B. Association Between Leverage and Endogenous Factors Results Model References

Leverage is negatively correlated with Agency Harris & Raviv (1990a)

the interest coverage ratio and the

probability of reorganization following

default

Targets of an unsuccessful tender offer Control Harris & Raviv (1988)

have more debt than targets of proxy

fights or successful tender offer

Targets of successful proxy fights have Control Harris & Raviv (1988)

more debt than targets of unsuccessful

proxy fights

Targets of proxy fights have more debt Control Harris & Raviv (1988)

than targets of successful tender offers

Panel C. Announcement of Security Issues

Stock Price Model References

Increases on announcement of debt Agency Harris & Raviv (1990a), Stulz issues, debtfor-equity exchanges (1990), Hirshleifer & Thakor

or stock repurchases (1989)

Asymmetric Info. Ross (1977), Noe (1988), Narayanan

(1988), Poitevin (1989)

Control Harris & Raviv (1988), Stulz (1988),

Israel (Forthcoming)

Isn't affected by announcement of debt issue Asymmetric Info. Myers & Majluf (1984), Krasker (1986), Korajczyk, et al. (1990c) Decreases on announcement of equity issue Agency Harris & Raviv (1990a), Stulz

(1990), Hirshleifer & Thakor

(1989)

Asymmetric Info. Ross (1977), Myers & Majluf (1984),

Krasker (1986), Korajczyk, et al. (1990c), Noe (1988), Narayanan (1988), Poitevin (1989), Lucas &

McDonald (1990)

Control Harris & Raviv (1988), Stulz (1988),

Israel (Forthcoming)

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330 The Journal of Finance

Table II-(Continued)

Panel C. Announcement of Security Issues

Stock Price Model References

Decreases more the larger is the Asymmetric Info. Myers & Majluf (1984), Krasker informational asymmetry (1986), Korajczyk, et al. (1990c)

Decreases more the larger is the size of Asymmetric Info. Krasker (1986)

the issue

Increases if some proceeds of equity Asymmetric Info. Brennan & Kraus (1987)

issue used to repurchase debt

Increases on announcement of issue of Asymmetric Info. Constantinides & Grundy (1989)

convertible debt in exchange for equity

Panel D. Other Results

Result Model References

There is a pecking order: firms prefer Asymmetric Info. Myers & Majluf (1984), Krasker

internal finance, then issuing seunties (1986), Narayanan (1988)

iL order of inomsig sensitivity to

ftirm performance

There is no pecking order Asymmetric Info. Brennan & Kraus (1987), Noe (1988),

Constantinides & Grundy (1989)

Firms tend to issue equity following Asymmetric Info. Lucas & McDonald (1990)

abnormal price appreciation

Firms tend to issue Asymmetric Info. Myers & Majluf (1984), Korajczyk,

equity when information asymmetry et al. (1990c)

is smallest

Bonds can be expected to have covenants Agency Jensen & Meckling (1976)

prohibiting "asset substitution"

Firms with longer track records have Agency Diamond (1989)

lower default probabilities

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The Theory of Capital Structure 331

and others (see Panel D). Since conflicting implications are rare, the large majority of the studies surveyed must therefore be considered as comple- ments, i.e., any or all of the effects traced by these theories could be present simultaneously. The relative significance of these effects is an empirical issue.

B. Summary of Empirical Evidence

The evidence fits into four categories. The first group contains evidence of general capital structure trends. The second group, event studies, generally measures the impact on stock value of an announcement of a capital struc- ture change. The third group relates firm/industry characteristics to finan- cial structure. The fourth group measures the relationship between capital structure and factors associated with corporate control. We discuss these four classes of empirical studies in the next subsections.

Before turning to this discussion, a word of caution is in order. The interpretation of the results must be tempered by an awareness of the difficulties involved in measuring both leverage and the explanatory vari- ables of interest. In measuring leverage, one can include or exclude accounts payable, accounts receivable, cash, and other short-term debt. Some studies measure leverage as a ratio of book value of debt to book value of equity, others as book value of debt to market value of equity, still others as debt to market value of equity plus book value of debt. With regard to the explana- tory variables, proxies are often difficult to interpret. For example, several studies measure growth opportunities as the ratio of market value of the firm to book value of assets. While firms with large growth opportunities should have large values of this ratio, other firms whose assets have appreciated significantly since purchase but which do not have large growth opportuni- ties will also have large values of this ratio. In addition to measurement problems, there are the usual problems with interpreting statistical results. In what follows, we take the results reported at face value and compare results of various studies largely ignoring differences in measurement tech- nique.

B.1. General Trends

Firms raise funds for new investment both externally, through security issues, and internally from retained earnings. Internal sources, which add to total firm equity, have historically constituted a large but fairly steadily declining fraction of these funds. For example, undistributed profits accounts for about 22% of total sources of funds for nonfarm, nonfinancial corporate business in 1986. By comparison, the same figure averaged about 49% over the period 1946-1966 (see Masulis (1988, Table 1-1, p. 3)).

The second major trend in financial structure has been the secular increase in leverage. Taggart (1985) reports secular trends in leverage using a variety of different measurements. He concludes that leverage has increased steadily since World War II but that current debt levels may not be high relative to

those of the prewar period.

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332 The Journal of Finance

B.2. Event Studies

Event studies have documented the stock price reaction to announcements

of security offerings, exchanges and repurchases.39 In some cases, the studies also document the reaction of earnings or earnings forecasts to the events. Generally, equity-increasing transactions result in stock price decreases while leverage-increasing transactions result in stock price increases. Earnings and earnings forecasts react consistently with the stock price reactions.

With regard to security issues,40

. abnormal returns associated with announcements of common stocks are the most negative (about - 3% according to Smith (1986)),

. abnormal returns associated with convertible bonds or convertible pre- ferred stock are more negative than those associated with the respective nonconvertible security,

. abnormal returns associated with straight debt or preferred stock are not statistically significantly different from zero,41

. abnormal returns associated with securities issued by utilities are less negative than those associated with the same securities issued by indus- trial firms.

Marsh (1982) finds that firms are more likely to issue long-term debt to the extent that their current long-term debt is below their target as measured by the average debt level of the previous 10 years. He also finds that market conditions play a highly significant role in determining the probability that a firm will issue debt. Specifically, firms are more likely to issue debt (equity)

when they expect other firms to issue debt (equity) and are more likely to issue equity to the extent that the previous year's share return exceeds that of the market portfolio. Korajczyk, et al. (1990a) also document that a firm's stock price experiences significant abnormal rises on average prior to its issuing equity. In addition, Korajczyk, et al. (1990b) find that equity issues are clustered after earnings announcements and the extent of the price drop at the announcement increases insignificantly with time since the last earn- ings announcement. Korajczyk, et al. (1990a) examine the cross-sectional properties of the price rise and track debt ratios and Tobin's q around the

time of equity issues. They find that debt ratios do not increase prior to equity issues, "suggesting that strained debt capacity is not the main reason for equity issues." Tobin's q (the ratio of market to book value of assets) is observed to rise prior to an equity issue and fall following the issue. This suggests that equity is issued to finance new investments.

39 Much of the literature is surveyed in Smith (1986). Masulis (1988) provides a more recent and comprehensive survey.

40See Asquith and Mullins (1986), Dann and Mikkelson (1984), Eckbo (1986), Linn and Pinegar (1988), Masulis and Korwar (1986), Mikkelson and Partch (1986), and Schipper and

Smith (1986).

41 Kim and Stulz (1988), however, found a significantly positive effect associated with Eu- robond issues.

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The Theory of Capital Structure 333

With regard to exchange offers, Masulis (1983) reports:42

. debt issued in exchange for common stock results in a 14% abnormal stock return.

. preferred stock issued in exchange for common stock results in a 8.3% abnormal stock return,

. debt issued in exchange for preferred stock results in a 2.2% abnormal stock return,

. common stock issued in exchange for preferred stock results in a - 2.6% abnormal stock return,

. common stock issued in exchange for debt results in a - 9.9% abnormal stock return,

. preferred stock issued in exchange for debt results in a - 7.7% abnormal stock return.

Further evidence on exchanges is offered by Lys and Sivaramakrishnan (1988), Cornett and Travlos (1989), and Israel, et al. (Forthcoming). Cornett and Travlos confirm Masulis' (1980, 1983) results that leverage increasing (decreasing) exchanges of securities are accompanied by positive (negative) abnormal common stock returns. They further document that abnormal price drops following leverage decreasing capital structure exchanges are posi- tively related to unexpected earnings decreases. Finally, they observe that abnormal price increases following leverage increasing capital structure exchanges are positively related to changes in managerial stock holdings. Lys and Sivaramakrishnan (1988) and Israel, et al. (Forthcoming) consider the effect of capital structure exchanges on the revisions of financial ana- lysts' forecasts. In a study of leverage decreasing exchanges, they find that analysts revise their forecasts of net operating income downward and that these revisions are positively correlated with the size of the stock price reaction to the exchange announcement.

Stock repurchases via tender offers result in sharp stock price increases. Masulis (1980) reports a 21% abnormal stock return, Dann (1981) finds a 15.4% abnormal stock return, and Vermaelen (1981) documents a 13.3% abnormal stock return. Consistent with this evidence, Dann, et al. (1989) document positive earnings surprises subsequent to tender offer stock repur- chases (but not before).

B.3. Firm and Industry Characteristics

The most basic stylized facts concerning industry characteristics and capi- tal structure are that firms within an industry are more similar than those in different industries and that industries tend to retain their relative leverage ratio rankings over time (Bowen, et al. (1982), Bradley et al. (1984)). Leverage ratios of specific industries have been documented by Bowen, et al. (1982), Bradley, et al. (1984), Long and Malitz (1985), and Kester (1986). Their results are in broad agreement and show that Drugs, Instruments,

42 See also Masulis (1980), Eckbo (1986), Mikkelson and Partch (1986), Pinegar and Lease (1986), and Cornett and Travlos (1989).

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