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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 tradeoff theory creates the same results thatbeing used to support pecking order theory.

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Question
Would our interpretation of crosssectional 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 AllEquity 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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The Case of an AllEquity Firm
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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The Case of an AllEquity Firm
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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The Case of a Levered Firm
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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The Case of a Levered Firm
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 closedform 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 crosssectional results are different at refinpoints;
Second use data from the model and run conventional crosssestudies from other authors.

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Regression analysis
Leverageprofitability 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.