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.

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Do Tests of Capital Structure Theory Mean What They Say?