Finance Articles

334 The Journal of Finance

Electronics, and Food have consistently low leverage while Paper, Textile

Mill Products, Steel, Airlines, and Cement have consistently high leverage. Moreover, regulated industries (Telephone, Electric and Gas Utilities and

Airlines) are among the most highly levered firms according to the study by Bradley, et al. (1984). The evidence on industry leverage ratios is summa-

rized in Table III.

Several studies shed light on the specific characteristics of firms and industries that determine leverage ratios (Bradley, et al. (1984), Castanias

(1983), Long and Malitz (1985), Kester (1986), Marsh (1982), and Titman and

Wessels (1988)). These studies generally agree that leverage increases with fixed assets, nondebt tax shields, growth opportunities, and firm size and decreases with volatility, advertising expenditures, research and develop- ment expenditures, bankruptcy probability, profitability and uniqueness of the product. These results are summarized in Table IV. In addition to the evidence cited in Table IV, Castanias (1983) also finds a negative correlation between leverage and default probability.

B.4. Corporate Control Considerations

Finally, since capital structure is used as an antitakeover device (DeAngelo

and DeAngelo (1985), Dann and DeAngelo (1988), and Amihud, et al. (1990)),

Table III

Industry Leverage Rankings Rankings of industries by leverage ratio are reported based on four studies: Bradley, et al. (1984, Table 1) [denoted BJK], Bowen, et al. (1982, Exhibit 1) [BDH], Long and Malitz (1985, Table 3)

[LM], and Kester (1986, Exhibit 2). We have listed industries from lowest to highest based on average debt-to-value ratio over the period 1962-1981 using Bradley, et al. The classification into "Low," "Medium," and "High," is our own and is somewhat arbitrary. The rankings in Bowen, et al. are an average of rankings over the period 1951-1969 based on long-term plus

short-term debt divided by total assets. For Long and Malitz, "Low" ("High") means that the industry was one of the five lowest (highest) in leverage ratio (book value of long-term funded debt divided by total funded capital) out of a sample of 39 firms. The rankings for Kester are based on the average of net debt divided by market value of equity for a sample of 344 Japanese and 452 U.S. companies in 27 industries over the period April, 1982 through March, 1983.

Industry BJK 13DH LM Kester

Drugs Lowa Low Low

Cosmetics Low Low Mediumb Instruments Low LowC Lowd Metal Mining Low

Publishing Low

Electronics Low Lowe Low Machinery Low Mediumf Food Low Lowg

Petroleum Exploration Medium

Construction Medium

Petroleum Refining Medium Lowh High High Metal Working Medium Chemicals Medium Medium High

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The Theory of Capital Structure 335

Table III-(Continued)

Industry BJK BDH LM Kester

Apparel Medium Medium Lumber Medium

Motor Vehicle Parts Medium Medium' Lowi Medium Paper Medium High High Textile Mill Products High Medium High High Rubber High Medium Retail Department Stores High Medium Retail Grocery Stores High Medium Trucking High

Steel High Low High High Telephone High Electric and Gas Utilities High Airlines High High

Cement High High Glass High

a Drugs (SIC code 2830) and Cosmetics (SIC code 2840) are combined. b Soaps and Detergents (SIC code 2841) part of Cosmetics (SIC code 2840) only. c Photographic Equipment (SIC code 3861) part of Instruments (SIC code 3800) only. d Photographic Equipment (SIC code 3861) part of Instruments (SIC code 3800) only. 'Radio and TV Receiving (SIC code 3651) part of Electronics (SIC code 3600) only. f Construction Machinery, Agricultural Machinery, and Machine Tools (SIC codes 3530, 3520,

3540).

g Confectionery and Alcoholic Beverages (SIC codes 2065, 2082, 2085) part of Food (SIC code 2000) only.

hOil-Integrated Domestic (SIC code 2912) part of Petroleum Refining (SIC code 2900) only. 1 BDH split Motor Vehicle Parts (SIC code 3700) into Auto Parts and Accessories (SIC code

3714) and Aerospace (SIC code 3721). In their study, the former ranks consistently at or near the lowest leverage ratio while the latter ranks near the highest.

J Aircraft (SIC code 3721) part of Motor Vehicle Parts (SIC code 3700) only.

several studies of the market for corporate control have produced evidence about capital structure. First, leverage is positively correlated with the extent of managerial equity ownership (Kim and Sorensen (1986), Agrawal and Mandelker (1987), Amihud et al. (1990)).43 Second, Dann and DeAngelo (1988) find that hostile bidders rarely prevail in the face of capital restructur- ing. Indeed, Palepu (1986) finds that leverage is negatively correlated with the probability of being successfully taken over. Third, stock price decreases following dual class recapitalization and other defensive strategies (Partch (1987), Dann and DeAngelo (1988), and Jarrell and Poulsen (1988)). Fourth, claims with superior voting power command higher prices than similar claims with inferior voting power (Levy (1983), Lease, et al. (1984), DeAngelo and DeAngelo (1985)). Fifth, high free cash flow is associated with higher probability of going private and larger premiums paid to stockholders upon going private (Lehn and Poulsen (1989)). Sixth, the distribution of equity

43 Friend and Hasbrouck (1988) and Friend and Lang (1988) find evidence to the contrary, although in the former the sign is insignificant.

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336 The Journal of Finance

Table IV

Determinants of Leverage The sign of the change in leverage as a result of an increase in the given characteristic is shown

for each of six studies. Blank entry indicates that the specific study did not include the given

characteristic. The studies are Bradley, et al. (1984) [denoted BJK], Chaplinsky and Niehaus (1990) [CN], Friend and Hasbrouck (1988), and Friend and Lang (1988) [FH/L], Gonedes, et al.

(1988) [GLC], Long and Malitz (1985) [LM], Kester (1986) [Kest.], Kim and Sorensen (1986) [KS], Marsh (1982) [Mar.], and Titman and Wessels (1988) [TW]. Comparisons suffer from the fact that these studies used different measures of the firm characteristics, different time periods, different leverage measures, and different methodologies.

Characteristic BJK CN FH/L GLC LM Kest. KS Mar.a TW

Volatility * + - *

Bankruptcy

Probability

Fixed Assets + + + + + Non-Debt Tax + + _ *

Shields

Advertising b R&D

Expenditures

Profitability - - * +

Growth - * +

Opportunities Size - * + * - - +

Free Cash Flow

Uniqueness'

a Marsh measures the probability of issuing debt conditional on issuing securities and on firm characteristics. The sign indicates the direction of change of this probability given a change in

the indicated characteristic.

b Advertising and R & D expenditures are combined. c This refers to the uniqueness of the product and is included specifically to test the model of

Titman (1984).

*Indicates that the result was either not statistically significantly different from zero at conventional significance levels or that the result was weak in a nonstatistical sense.

ownership seems to play a role in both managerial behavior and capital structure. In particular, Agrawal and Mandelker (1987) find that when managers own a larger share of the equity they tend to choose higher

variance targets. Also, Friend and Lang (1988) and Gonedes, et al. (1988) find that leverage is lower in firms with dispersed outside ownership.

C. Comparison of Theoretical Predictions and Empirical Evidence

This subsection integrates the information described in the previous two subsections. Table V matches the empirical evidence with the theoretical results in Table II. Table V is organized exactly as Table II except that

columns two and three of Table II are replaced by the evidence. Specifically, for each theoretical result we list the relevant empirical studies divided into two groups: those consistent with the prediction (indicated by "Yes") and those inconsistent with it (indicated by "No").

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The Theory of Capital Structure 337

Table V

Comparison of Theoretical and Empirical Results

The table lists, for each theoretical result in Table II, those empirical studies whose findings are either consistent (after the word "Yes:") or inconsistent (after "No:") with the theoretical result. Blank cells indicate the lack of empirical

evidence.

Panel A. Association Between Leverage and Exogenous Factors

Leverage increases with: Empirical Evidence

Extent of information asymmetry

Increases in profitability Yes: Long & Malitz (1985)*

No: Kester (1986), Friend & Hasbrouck (1988), Friend &

Lang (1988), Gonedes, et al. (1988), Titman & Wessels (1988)

Extent of strategic interaction in the product market

Elasticity of demand for the product

Extent to which product is not unique and does not require Yes: Titman & Wessels (1988)

specialized service

Extent to which reputation for product quality is

unimportant

Extent to which workers are unionized or have

transferrable skills

Extent to which the firm is a takeover target or lack of

anti-takeover measures

Potential gains to takeover and reductions in their costs

Fraction of cash flow that is unobservable

Lack of growth opportunities Yes: Kim & Sorensen (1986), Titman & Wessels (1988),*

Chaplinsky & Niehaus (1990)*

No: Kester (1986)

Extent of regulation Yes: Bowen, et al. (1982), Bradley, et al. (1984)

Increases in free cash flow No: Chaplinsky & Niehaus (1990)

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338 The Journal of Finance

Table V-(Continued)

Panel A. Association Between Leverage and Exogenous Factors

Leverage increases with: Empirical Evidence

Increases in liquidation value Yes: Bradley, et al. (1984), Long & Malitz (1985), Friend & Hasbrouck (1988), Friend & Lang (1988),

Gonedes, et al. (1988), Titman & Wessels (1988),*

Chaplinsky & Niehaus (1990)

No: Kim & Sorensen (1986), Titman & Wessels (1988)*

Decreases in investigation costs

Increases in the importance of managerial reputation

Panel B. Association Between Leverage and Endogenous Factors

Result Empirical Evidence

Leverage is positively correlated with firm value Yes: Lys & Sivaramakrishnan (1988), Cornett &

Travlos (1989), Dann, et al. (1989), Israel, et al.

(Forthcoming)

Leverage is positively correlated with default No: Castanias (1983)

probability

Leverage is positively correlated with the extent of Yes: Kim & Sorensen (1986), Agrawal & managerial equity ownership Mandelker (1987), Amihud, et al. (1990)

No: Friend & Hasbrouck (1988),* Friend & Lang

(1988)

Leverage is positively correlated with target premium

Leverage is negatively correlated with probability of Yes: Palepu (1986)

successful takeover

Leverage is negatively correlated with the interest

coverage ratio and the probability of reorganization

following default

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The Theory of Capital Structure 339

Table V- (Continued)

Panel B. Association Between Leverage and Endogenous Factors

Result Empirical Evidence

Targets of an unsuccessful tender offer have more

debt than targets of proxy fights or successful tender

offers

Targets of successful proxy fights have more debt

than targets of unsuccessful proxy fights

Targets of proxy fights have more debt than targets

of successful tender offers

Panel C. Announcement of Security Issues

Stock price: Empirical Evidence

Increases on announcement of debt issue Yes: Kim & Stulz (1988)

No: Dann & Mikkelson (1984),* Eckbo (1986),*

Mikkelson & Partch (1986)*

Increases on announcement of debt for equity Yes: Masulis (1980, 1983), Cornett & Travlos

exchange (1989)

Increases on announcement of stock repurchase Yes: Masulis (1980), Dann (1981), Vermaelen

(1981), Dann, et al. (1989)

Decreases on announcement of equity issue Yes: Asquith & Mullins (1986), Masulis & Korwar

(1986), Mikkelson & Partch (1986), Schipper and

Smith (1986)

Decreases on announcement of equity for debt Yes: Masulis (1980, 1983), Eckbo (1986),

exchange Mikkelson & Partch (1986), Cornett & Travlos

(1989)

Decreases more the larger is the informational Yes: Korajczyk, et al. (1990b)*

asymmetry

Decreases more the larger is the size of the issue Yes: Asquith & Mullins (1986)

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340 The Journal of Finance

Table V-(Continued)

Panel C. Announcement of Security Issues

Increases if some proceeds of equity issue used to

repurchase debt

Increases on announcement of issue of convertible

debt in exchange for equity

Panel D. Other Results

Result Empirical Evidence

There is a pecking order: firms prefer internal Yes: Chaplinsky & Niehaus (1990), Amihud,

finance, then issuing securities in order of increasing et al. (1990)

sensitivity to firm performance No: Korajczyk, et al. (1990a)

Firms tend to issue equity following abnormal price Yes: Marsh (1982), Korajczyk, et al. (1990a)

appreciation

Firms tend to issue equity when information Yes: Korajczyk, et al. (1990b)

asymmetry is smallest

Low returns optimally entail change of control or

ownership

Bonds can be expected to have covenants prohibiting Yes: Smith & Warner (1979)

"asset substitution"

Firms with longer track records have lower default

probabilities

k = weak or statistically insignificant relationship.

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