Finance Articles

The Theory of Capital Structure 341

The evidence cited in Table V is either direct evidence about the particular result or, in some cases, represents an interpretation of the actual indepen- dent variable used in the study. In particular, the following interpretations are embedded in Table V.

. Extent of regulation: telephone, electric and gas utilities, and airlines are both highly regulated and highly levered as indicated in Table III.

. Liquidation value: fixed assets and nondebt tax shields are generally regarded as proxies for the tangibility or liquidation value of assets. On the other hand, research and development and advertising expenditures can be interpreted as measuring the extent to which assets are intangi- ble. See Table IV.

. Firm value: in Panel B, the studies cited document increases in earnings or earnings forecasts following leverage increases.

. Pecking order: the fact that leverage decreases with internal funds is interpreted as evidence that firms prefer to use internal financing before issuing debt (Chaplinsky and Niehaus (1990)). Also, Amihud, et al. (1990) find that, in acquisitions, managers prefer to finance with cash or debt rather than equity, at least when they have a large equity stake. Finally, Korajczyk, et al. (1990a) interpret the fact that debt ratios do not increase prior to equity issues used to finance investment as evidence that "strained debt capacity is not the main reason for equity issues."

Other evidence from Table III (industry leverage ratio rankings) may conceivably bear on the predictions of the theory. For example, one might argue that the airline industry is marked by a high degree of strategic interaction across firms. If so, the fact that airlines are highly levered is consistent with the results of Brander and Lewis (1986). Similarly, if reputa- tion for product quality is especially important in the drug industry, the fact that drug firms have low leverage is consistent with the results of Maksi- movic and Titman (Forthcoming). Also, to the extent that trucking is highly unionized, the high leverage found in this industry supports the model of Sarig (1988). Obviously, such inferences depend on detailed knowledge of the industries involved-knowledge we do not possess.

In addition to Table V, which matches the empirical evidence with the theoretical results, we also present, in Table VI, those empirical findings that do not bear on any specific theoretical prediction. Some of these lend support to the assumptions of certain models. Others provide evidence to be ex- plained.

Finally, in Table VII, we organize the information in Table V to present the theoretical results and the evidence by model type. In Panels A through D we list, in turn, the implications of agency models (Panel A), asymmetric information models (Panel B), product/input market models (Panel C), and corporate control models (Panel D). The results are ordered, in each panel, so that those with evidence are listed first, followed by those for which there is no available evidence. Table VII is useful for determining whether any model or class of models has been rejected by the evidence and what additional evidence would be useful for testing the models.

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342 The Journal of Finance

Table VI

Other Empirical Results This table lists empirical evidence not directly related to any theoretical result.

Empirical Result Source

The extent of external financing has increased Masulis (1988) over time

Total leverage has increased steadily since Taggart (1985) World War II

Capital structure is used to protect control DeAngelo & DeAngelo (1985), Dann &

DeAngelo (1988), Amihud, et al. (1990)

Hostile bidders rarely prevail in face of capital Dann & DeAngelo (1988)

restructuring

Dual class recapitalization and other defensive Partch (1987),* Dann & DeAngelo (1988),

strategies result in stock price decrease Jarrell & Poulsen (1988)

Stock price increases with voting power Levy (1983), Lease, et al. (1984), DeAngelo & DeAngelo (1985)

High free cash flow is associated with higher Lehn & Poulsen (1989)

probability of going private and higher premiums

Firms more likely to issue debt if current debt Marsh (1982) level is below target

Leverage decreases with return volatility Bradley, et al. (1984), Kester (1986),* Friend

& Hasbrouck (1988), Friend & Lang (1988),

Titman & Wessels (1988)*

Leverage increases with increases in operating Kim & Sorensen (1986) risk

Leverage decreases with increases in firm size Yes: Kester (1986),* Kim & Sorensen (1986),* Titman & Wessels (1988)* No: Friend & Hasbrouck (1988),* Friend & Lang (1988)*

High inside ownership is associated with return Agrawal & Mandelker (1987) variance increasing investments

Leverage decreases with increases in dispersion Friend & Lang (1988), of Gonedes, et al. outside ownership (1988)

*= weak or statistically insignificant relationship.

VI. Conclusions

The theories surveyed here have identified a great many potential determi- nants of capital structure (in addition to taxes). These can be most easily seen in Table II, Panels A and D. Since the theories are, for the most part, complementary, which of these factors is important in various contexts remains a largely unanswered empirical question.

Although many potential factors emerge from the theory, a fairly small number of "general principles" is evident. The literature that takes debt and

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The Theory of Capital Structure 343

Table VII

Summary of Results by Model Type

The table shows, for each model type, the main results [with sources in brackets] and the empirical studies whose findings

are either consistent (after the word "Yes:") or inconsistent (after "No:") with the theoretical result.

Panel A. Agency Models

Theoretical Result [source] Empirical Evidence

Stock price increases on announcement of debt issues, Debt Issues

debt-for-equity exchanges, or stock repurchases and Yes: Kim & Stulz (1988)

decreases on announcement of equity issues or equity- No: Dann & Mikkelson (1984),* Eckbo (1986),*

for-debt exchanges [Harris & Raviv (1990a), Stulz Mikkelson & Partch (1986)*

(1990), Hirshleifer & Thakor (1989)] Debt-for-Equity Exchanges

Yes: Masulis (1980, 1983), Cornett & Travlos

(1989)

Stock Repurchases

Yes: Masulis (1980), Dann (1981), Vermaelen

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

Equity Issues

Yes: Asquith & Mullins (1986), Masulis & Korwar (1986), Mikkelson & Partch (1986),

Schipper and Smith (1986)

Equity-for-Debt Exchanges

Yes: Masulis (1980, 1983), Eckbo (1986),

Mikkelson & Partch (1986), Cornett & Travlos

(1989)

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

[Harris & Raviv (1990a), Stulz (1990), Travlos (1989), Dann, et al. (1989), Israel, et al.

Hirshleifer & Thakor (1989)] (1990)

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

probability [Harris & Raviv (1990a)]

Leverage increases with lack of growth opportunities Yes: Kim & Sorensen (1986), Titman & Wessels

[Jensen & Meckling (1976), Stulz (1990)] (1988),* Chaplinsky & Niehaus (1990)*

No: Kester (1986)

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344 The Journal of Finance

Table VII-(Continued) Panel A. Agency Models

Theoretical Result [source] Empirical Evidence

Leverage increases with decreases in profitability Yes: Kester (1986), Friend & Hasbrouck (1988),

[Chang (1987)] Friend & Lang (1988), Gonedes, et al. (1988),*

Titman & Wessels (1988) No: Long & Malitz (1985)*

Leverage increases with extent of regulation [Jensen Yes: Bowen, et al. (1982), Bradley, et al.

& Meckling (1976), Stulz (1990)] (1984)

Leverage increases with increases in free cash flow No: Chaplinsky & Niehaus (1990)

[Jensen (1986), Stulz (1990)]

Leverage increases with increases in liquidation value Yes: Bradley, et al. (1984), Long & Malitz

[Williamson (1988), Harris & Raviv (1990a)] (1985), Friend & Hasbrouck (1988), Friend &

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

Wessels (1988),* Chaplinsky & Niehaus (1990) No: Kim & Sorensen (1986), Titman & Wessels

(1988)*

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

"asset substitution" [Jensen & Meckling (1976)]

Leverage is negatively correlated with the interest

coverage ratio and the probability of reorganization

following default [Harris & Raviv (1990a)]

Leverage increases with fraction of cash flow that is

unobservable [Chang (1987)]

Leverage increases with extent to which the firm is a

takeover target or lack of anti-takeover measures

[Stulz (1990), Hirshleifer & Thakor (1989)]

Firms with longer track records have lower default

probabilities [Diamond (1989)]

Leverage increases with decreases in investigation

costs [Harris & Raviv (1990a)]

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The Theory of Capital Structure 345

Table VII-(Continued) Panel A. Agency Models

Theoretical Result [source] Empirical Evidence

Leverage increases with increases in the importance

of managerial reputation [Hirshleifer & Thakor

(1989)]

Panel B. Asymmetric Information Models

Theoretical result [source] Empirical Evidence

Stock price increases on announcement of debt Debt Issues

issues, debt-for-equity exchanges, or stock Yes: Kim & Stulz (1988)

repurchases and decreases on announcement of No: Dann & Mikkelson (1984),* Eckbo (1986),*

equity-for-debt exchanges [Ross (1977), Noe (1988), Mikkelson & Partch (1986)*

Narayanan (1988), Poitevin (1989)] Debt-for-Equity Exchanges

Yes: Masulis (1980, 1983), Cornett & Travlos

(1989)

Equity-for-Debt Exchanges

Yes: Masulis (1980, 1983), Eckbo (1986),

Mikkelson & Partch 91986), Cornett & Travlos

(1989)

Stock Repurchases

Yes: Masulis (1980), Dann (1981), Vermaelen

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

Stock price is unaffected by debt issues [Myers & See previous cell

Majluf (1984), Krasker (1986), Korajczyk, et al.

(1990c)]

Leverage increases with increases in profitability Yes: Long & Malitz (1985)*

[Ross (1977), Leland & Pyle (1977), Heinkel No: Kester (1986), Friend & Hasbrouck (1988), (1982), Blazenko (1987), John (1987), Poitevin Friend & Lang (1988), Gonedes, et al. (1988),*

(1989)] Titman & Wessels (1988)

Leverage increases with decreases in free cash flow Yes: Chaplinsky & Niehaus (1990)

[Myers & Majluf (1984)]

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346 The Journal of Finance

Table VII-(Continued)

Panel B. Asymmetric Information Models

Theoretical Result [source] Empirical Evidence

Stock price decreases on announcement of equity Yes: Asquith & Mullins (1986), Masulis & Korwar issue [Ross (1977), Myers & Majluf (1984), (1986), Mikkelson & Partch (1986), Schipper and

Krasker (1986), Korajczyk, et al. (1990c), Noe Smith (1986)

(1988), Narayanan (1988), Poitevin (1989), Lucas

& McDonald (1990)]

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 [Myers & Majluf No: Korajczyk, et al. (1990a)

(1984), Krasker (1986), Narayanan (1988)]

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

[Ross (1977), Noe (1988), Narayanan (1988), Travlos (1989), Dann, et al. (1989), Israel, et al.

Poitevin (1989)] (Forthcoming)

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

probability [Ross (1977)]

Leverage is positively correlated with the extent of Yes: Kim & Sorensen (1986), Agrawal & managerial equity ownership [Leland & Pyle (1977)] Mandelker (1987), Amihud, et al. (1990)

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

(1988)

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

appreciation [Lucas & McDonald (1990)]

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

asymmetry is smallest [Myers & Majluf (1984),

Korajczyk, et al. (1990c)]

Stock price decreases more the larger is the Yes: Korajczyk, et al. (1990b)*

informational asymmetry [Myers & Majluf (1984),

Krasker (1986), Korajczyk, et al. (1990c)]

Leverage increases with extent of information

asymmetry [Myers & Majluf (1984)]

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The Theory of Capital Structure 347

Table VII-(Continued)

Panel B. Asymmetric Information Models

Theoretical result [source] Empirical Evidence

Stock price decreases more the larger is the size of Yes: Asquith & Mullins (1986)

the issue [Krasker (1986)]

Stock price increases if some proceeds of equity issue used to repurchase debt [Brennan & Kraus

(1987)]

Stock price increases on announcement of issue of

convertible debt in exchange for equity

[Constantinides & Grundy (1989)]

Panel C. Product/Input Market Models

Theoretical Result [source] Empirical Evidence

Leverage increases with extent to which product is Yes: Titman & Wessels (1988)

not unique and does not require specialized service

[Titman (1984)]

Leverage increases with extent of strategic

interaction in the product market [Brander & Lewis

(1986)]

Leverage increases with elasticity of demand for the

product [Maksimovic (1988)]

Leverage increases with extent to which reputation for product quality is unimportant [Maksimovic &

Titman (Forthcoming)]

Leverage increases with extent to which workers are

unionized or have transferable skills [Sarig (1988)]

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348 The Journal of Finance

Table VII-(Continued)

Panel D. Corporate Control Models

Theoretical Result [source] Empirical Evidence

Stock price increases on announcement of debt Debt Issues

issues, debt-for-equity exchanges, or stock Yes: Kim & Stulz (1988)

repurchases and decreases on announcement of No: Dann & Mikkelson (1984),* Eckbo (1986),*

equity issues or equity-for-debt exchanges [Harris & Mikkelson & Partch (1986)*

Raviv (1988), Stulz (1988), Israel (Forthcoming)] Debt-for-Equity Exchanges

Yes: Masulis (1980, 1983), Cornett & Travlos

(1989)

Stock Repurchases

Yes: Masulis (1980), Dann (1981), Vermaelen

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

Equity Issues

Yes: Asquith & Mullins (1986), Masulis & Korwar

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

Smith (1986)

Equity-for-Debt Exchanges

Yes: Masulis (1980, 1983), Eckbo (1986),

Mikkelson & Partch (1986), Cornett & Travlos

(1989)

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

[Harris & Raviv (1988), Stulz (1988), Israel Travlos (1989), Dann, et al. (1989), Israel, et al.

(Forthcoming)] (Forthcoming)

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

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

(1988)

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

successful takeover [Stulz (1988)]

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