Do Tests of Capital Structure Theory Mean What They Say?

8/10/2019 Do Tests of Capital Structure Theory Mean What They Say?

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Do Tests of CapitalStructure Theory Mean

What They Say?Ilya A. Strebulaev, Stanford University.


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Introduction

Recent empirical research: Focuses on regularities in the cross section of leverage to discriminate be

various theories of financing policy.

Support pecking order theory in face of cross section evidence.

The author: Companies adjust their capital structure infrequently;

Proposes a dynamic model where at any time the majority of companies at a refinancing point;

A model constructed using trade-off theory creates the same results thatbeing used to support pecking order theory.


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Question

Would our interpretation of cross-sectional tests change if firmoptimally adjusted their leverage only infrequently?


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How the paper is organized

Section I - The model;

Section II - Simulation and empirical tests;

Section III - Robustness tests;

Section IV - Conclusion.


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The Model


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The Case of an All-Equity Firm

Economy populated by Nfirms;

Firm endowed with monopoly access to infinitely lived project;

Value of firm comes from present and future income from proje

Cash flows are invariant to financial policy (Miller and Modiglian

Investment = Retained Earnings;

Book assets grow byg;

Claimholders = Equity, Debt, Gov., costs.


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Net payout to claimholders, , is governed by:

andare constant; is the risk neutral drift;

is the instanteneously volatility of the projectscash flow;

Z is a Brownian motion.


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Shareholdersvalue =

are taxes;


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The Case of a Levered Firm

Debt is in the form of a perpetuity entitling debtholders to a strof continuos payments at the rate of c per annum;

Equity holders can call debt at any time at face value.


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Path 1 retire outstanding debt; sell a new, larger issue to takeadvantage of tax benefits associated with debt;

Path 2 and 3 sell fraction of assets to retire debt;

Path 2 same as path one;

Path 3 default;


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Corrective action at Path 2 and 3 is modeled as follows.

Firm sells fraction 1 ;

D = par value of debt;

V = present value of project;

qA = proportional cost of selling assets;

qRC = adjustment costs of issuing/retiring debt.


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Scaling feature

Since all costs are proportional to the value of the firm or its claimany refinancing point, the firm is just a large replica of itse


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So...

Therefore, the values of equity and debt can be computed for fodifferent cenarios: Firm is financially healthy (Path 1)

After it hits the liquidity barrier for the 1st time (Path 2 and 3)

After barrier is hit (Path 2)

Default (Path 3)


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Equity

The values of equity in one refinancing cyle at time t= 0 is:

1st term is the PV when neither barriers have been reached;

2nd term is the PV after liquidity barrier has been reached;

3rd term is the valued received in default.


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Debt

The values of debt in one refinancing cyle at time t= 0 is:

1st and 3rd term are the NPV of payout to debtholders before and after licrisis;

2nd term reflects debt purchased when assets are sold;

4th term reflects default.


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Equity

The total value of all payouts to equity (except at refinincing pois given by:


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Debt

The total value of all debt issues is:


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Combining the two...

Combining these values yields the total value of the firm that eqholders maximize at time t = 0:


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And...

Equity holders choose the coupon and barriers to maximize theante value of their claim.


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Net payout ratio

The author assumes the net payout ratio depends linearly on thafter tax coupon rate.

V= PV of all future payouts.


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Did not understand


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Numerical approach

Solving F() subject to Net Payout Ratio and the smoot passincondition;

A closed-form solution to this problem does not exist, and thusstandard numerical procedures are used.


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Simulation


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Simulation

300 quarters of data for 3,000 firms; To minimize impacts of initial conditions, drop the first 152 qua

This equals to one "economy";

Repeat simulations for 1,000 economies.


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Parameters

Whenever possible, use other authors; Complement with robustness tests.


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Empirical Tests


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Empirical Tests

First study whether cross-sectional results are different at refinpoints;

Second use data from the model and run conventional cross-sestudies from other authors.


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Regression analysis

Leverage-profitability relationship; Leverage and stock returns;

Changes in leverage and mean reversion;

Regressions on subsamples.


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Leverage and stock returns

Welch (2004): U.S. corporations do not change their capital struto offset the mechanistic effect on leverage of changes in their price;

Teh simulations clearly show that a model with small adjustmencosts can produce results on the persistence of leverage that arconsistent with those observed in reality.


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The implied debt ratio shows the response of leverage only to changesf1= 1 means firms do not reajust at all;

f2= 1 mean firms perfectly offset any change in equity.


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Changes in leverage and mean reversio

Not surprisingly, leverage in the model is mean reverting; Fama and French (2002) report similar numbers for mean rever


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Regressions on subsamples

Profitability almost loses explanatory power on the activesubsample.


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Robustness Tests


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Concluding Remarks


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Concluding Remarks

The properties of leverage in the cross section in true dynamicsin comparative statics at refinancing points differ dramatically;

The model generates data that using methodologies commonlemployed in the literature may lead to the rejection of the moditself as explanation of the data.

Do Tests of Capital Structure Theory Mean What They Say?

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