Does debt capacity matter in the choice of debt in reducing the underinvestment problem?

We test the impact of debt capacity on firms’ simultaneous decisions of leverage and debt maturity in reducing underinvestment problems. Examining 24 OECD countries for the period between 1990 and 2011, we find strong evidence, that, unlike previous studies, the role of leverage and debt maturity in reducing underinvestment problems is not homogeneous across firms with varied debt capacity. We find new evidence that, when firms face lower debt capacity constraints, they benefit from their ability to use a greater amount of debt if they shorten their debt maturity, or gain from using longer maturity of debt if they decrease their leverage to reduce underinvestment problems. Our results suggest that they also benefit from the ability of their firms to gain from interest tax shields by financing more with debt or long-term debt, and hence use debt maturity and leverage as strategies substitutes. However, when firms are constrained by concerns over debt capacity, they tend to opt for a lower level of debt that is mainly short-term to reduce the underinvestment problem. Our results suggest that firms with lower debt capacity cannot completely resolve their underinvestment problems by using short-term debt or low leverage, implying that the effects of the liquidity risk outweigh those of underinvestment problems, and hence impose a constraint on firms’ choice of debt.     

A two-part fractional regression model for the financial leverage decisions of micro,small, medium and large firms

In this paper we examine the following two hypotheses, which traditional theories of capital structure are relatively silent about: (i) the determinants of financial leverage decisions are different for micro, small, medium and large firms; and (ii) the factors that determine whether or not a firm issues debt are different from those that determine how much debt it issues. Using a binary choice model to explain the probability of a firm raising debt and a fractional regression model to explain the relative amount of debt issued, we find strong support for both hypotheses. Confirming recent empirical evidence, we find also that, although larger firms are more likely to use debt, conditional on their having some debt, firm size is negatively related to the proportion of debt used by firms.     

Investor sentiment and firm capital structure

We provide novel evidence of the role of investor sentiment in determining firms' capital structure decisions from three perspectives: leverage ratio, debt maturity and leverage target adjustment. We find that when investor sentiment is high, firms increase their leverage ratios, supporting our contention that high investor sentiment increases firms' debt capacity and facilitates the use of an aggressive leverage policy. Debt maturity is shorter in high sentiment periods, implying that firms are confident about future earnings and use shorter debt maturity to signal their financial solvency. Leverage target adjustment is slower in low sentiment periods, indicating higher costs of external finance. Furthermore, the sentiment-leverage relationship sensitivity is greater for financially constrained firms. Our extended analysis determines that leverage-increasing firms generate lower stock returns subsequent to a period of high sentiment, offering practical insights into the economic consequences of increasing leverage in high sentiment periods on corporate value for investors. Our research advances the understanding of the impact of investor sentiment on firms' financing decisions and stock returns.     

The Maturity Structure of Corporate Debt

We provide an empirical examination of the determinants of corporate debt maturity. Our evidence offers strong support for the contracting-cost hypothesis. Firms that have few growth options, are large, or are regulated have more long-term debt in their capital structure. We find little evidence that firms use the maturity structure of their debt to signal information to the market. The evidence is consistent, however, with the hypothesis that firms with larger information asymmetries issue more short-term debt. We find no evidence that taxes affect debt maturity.     

Capital Structure, CEO Dominance, and Corporate Performance

We use agency theory to investigate the influence of CEO dominance on variation in capital structure. Due to agency conflicts, managers may not always adopt leverage choices that maximize shareholders’ value. Consistent with the prediction of agency theory, the evidence reveals that, when the CEO plays a more dominant role among top executives, the firm adopts significantly lower leverage, probably to evade the disciplinary mechanisms associated with debt financing. Our results are important as they demonstrate that CEO power matters to critical corporate outcomes such as capital structure decisions. In addition, we find that the impact of changes in capital structure on firm performance is more negative for firms with more powerful CEOs. Overall, the results are in agreement with prior literature, suggesting that strong CEO dominance appears to exacerbate agency costs and is thus detrimental to firm value.     

The effects on investment incentives of an allowance for corporate equity tax system: the Belgian case as an example

The Modigliani–Miller theorem serves as the standard finance paradigm on corporate capital structure and managerial decision making. Implicitly, it is assumed that the market possesses full information about the firm. However, if firm managers have insider information, they may attempt to ‘signal’ changes in the firm’s financial structure and, in competitive equilibrium, shareholders will draw deductions from such signals. Empirical work shows that the value of underlying firms rises with leverage because investors expect such firms to implement positive NPV projects. We empirically examine this view using a sample of debt issue announcements by publicly traded firms listed on the London Stock Exchange. We argue that the timing of debt issues is fundamental in determining the relationship between leverage and risk-adjusted returns. We show that an announcing firm’s intrinsic value may not rise depending on when management publicly ‘signals’ changes in their firm’s capital structure. Specifically, we show that risk-adjusted returns rise positively for firms that make debt announcements during normal economic conditions while they tend to decline for firms making debt announcements during recessionary periods. During recessionary periods, market risk and loss aversion rise and investors focus less on the potential growth of debt announcing firms and focus more on potential losses instead. We conclude that the timing of new debt is of paramount importance and managers’ inability to prudently time such announcements can lead to exacerbated levels of systematic risk coupled with a significant erosion in shareholder wealth.     

Do firms have leverage targets? Evidence from acquisitions

In the context of large acquisitions, we provide evidence on whether firms have target capital structures. We examine how deviations from these targets affect how bidders choose to finance acquisitions and how they adjust their capital structure following the acquisitions. We show that when a bidder's leverage is over its target level, it is less likely to finance the acquisition with debt and more likely to finance the acquisition with equity. Also, we find a positive association between the merger-induced changes in target and actual leverage, and we show that bidders incorporate more than two-thirds of the change to the merged firm's new target leverage. Following debt-financed acquisitions, managers actively move the firm back to its target leverage, reversing more than 75% of the acquisition's leverage effect within five years. Overall, our results are consistent with a model of capital structure that includes a target level and adjustment costs.     

The global financial crisis and the capital structure of firms: Was the impact more severe among SMEs and non-listed firms?

Using a dataset covering about 276,998 firms across 75 countries over the period 2004–2011, this paper examines the short-run evolution of firms' capital structures following the start of the global financial crisis and its immediate aftermath, comparing the experience of already levered SMEs, large non-listed firms, and listed companies. We find that firm leverage and debt maturity declined both in advanced economies and in developing countries, even in those that did not experience a crisis. The deleveraging and maturity reduction were particularly significant for non-listed firms, including both SMEs as well as large non-listed companies. For SMEs, these effects were larger in countries with less efficient legal systems, weaker information sharing mechanisms, less developed financial sectors, and with more restrictions on bank entry. In contrast, there is weaker evidence of a significant decline in leverage and debt maturity among listed companies which are typically much larger than other firms and likely to benefit from the “spare tire” of easier access to capital market financing. Though our results are robust to many changes in sample and specification, we cannot rule out that survivorship bias and attrition could affect our estimates to some degree.     

Does the Source of Capital Affect Capital Structure?

Prior work on leverage implicitly assumes capital availabilitydepends solely on firm characteristics. However, market frictionsthat make capital structure relevant may also be associatedwith a firm’s source of capital. Examining this intuition,we find firms that have access to the public bond markets, asmeasured by having a debt rating, have significantly more leverage.Although firms with a rating are fundamentally different, thesedifferences do not explain our findings. Even after controllingfor firm characteristics that determine observed capital structure,and instrumenting for the possible endogeneity of having a rating,firms with access have 35% more debt.     

The determinants of debt maturity in Australian firms

We examine the determinants of debt maturity in the Australian capital market with the Top 400 firms listed on the Australian Securities Exchange for the period 1989–2006. We find that Australian firms not only exhibit a positive leverage–maturity relationship but also use short‐term debt to signal their high quality to the market. Our results are robust to different estimation methods that control for endogeneity and error‐dependence. We also find that ignoring the interaction between leverage and maturity can lead to erroneous conclusions about the support for the matching principle, the agency costs hypothesis and the transaction costs hypothesis.     

CEO's Inside Debt and Dynamics of Capital Structure

Debt‐type compensation (inside debt) exacerbates the divergence in risk preferences between the chief executive officer (CEO) and shareholders and, in turn, affects capital structure decisions. An excessively risk‐averse CEO tends to use less debt than the shareholders desire, reduce debt quickly when the firm is overlevered, but is reluctant to increase debt when the firm is underlevered. We find that higher CEO's inside debt ratio (i.e., inside debt as a percentage of total incentive compensation) is associated with lower firm leverage and faster (slower) leverage adjustments toward the shareholders’ desired level for overlevered (underlevered) firms. The CEO's inside debt ratio most conducive to capital structure rebalancing is around 10% of the firm's market debt ratio.     

An empirical analysis of corporate debt maturity structure

This paper provides an empirical investigation of the maturity structure of corporate debt. A dynamic model is estimated by GMM estimation procedure using data for an unbalanced panel of 429 non-financial UK firms over the period of 1983–96. The evidence provides strong support for the hypotheses that firms with more growth opportunities in their investment sets tend to have more shorter-term debt and firm size exerts a negative impact on debt maturity structure. The results also support the maturity-matching hypothesis that firms match the maturity structure of their debt to the maturity of their assets. There is less support for the view that firms use their debt maturity structure to signal information to the market. We do not find evidence for a negative correlation between taxes and debt maturity. Our results also suggest that firms have long-term target ratios and they adjust to the target ratio relatively fast, which might indicate that the costs of being away from target ratios are significant for firms.     

Systematic risk,debt maturity,and the term structure of credit spreads

We document several facts about corporate debt maturity: (1) debt maturity is pro-cyclical, (2) higher-beta firms tend to have longer maturity, and (3) shorter maturity amplifies the sensitivity of credit spreads to aggregate shocks. We present a dynamic capital structure model that explains these facts. In the model, leverage and maturity choices are interdependent, which reflect the tradeoffs of liquidity discounts of long-term debt, repayment risks of short-term debt, and the benefit of short-term debt as a commitment device for timely leverage adjustments. Additionally, the model helps quantify the effects of maturity dynamics on the term structure of credit spreads.     

The Effects of Ownership Structure and Intragroup Loans on Leverage: Evidence from Family Firms in Chile

This article examines the effects of family control and pyramidal ownership on firms’ capital structure decisions. After studying a sample of listed family and nonfamily firms in Chile, we find that families take a conservative approach to debt and financial risk exposure. We test the hypothesis that family firms restrict the use of debt in order to avoid the monitoring role of creditors, which could limit their enjoyment of the private benefits of control. In keeping with this hypothesis, we find a U-shaped relationship between leverage and the degree of pyramidal ownership that is more pronounced among family firms than nonfamily firms. We do not find any evidence that is consistent with the hypothesis that family-controlled firms have low leverage ratios due to their access to internal capital markets. In fact, conversely, we find that listed family firms provide more loans to related companies than comparable nonfamily firms.     

Leverage and investment in diversified firms

Within diversified firms, the negative impact of leverage on investment is significantly greater for high q than for low q segments and significantly greater for non-core than for core segments. This differs substantially from focused firms and is consistent with the view that diversified firms allocate a disproportionate share of their debt service burden to their higher q and non-core segments. We also find that, among low-growth firms, the positive relation between leverage and firm value is significantly weaker in diversified firms than in focused firms. We conclude that the disciplinary benefits of debt are partially offset by the additional managerial discretion in allocating debt service that is provided by the diversified organizational structure.     

Debt Financing and Earnings Management: An Internal Capital Market Perspective

This paper investigates the role internal capital markets play in mitigating earnings management of group firms. We predict that the funding advantages of internal capital markets from business affiliates obscure solvency problems resulting from higher leverage for individual firms within a group, which in turn mitigates their incentives for earnings management. Using Taiwanese firms as a sample, we provide evidence that is consistent with such a prediction. In particular, we show that higher group profitability reduces its member firms’ sensitivity of earnings management to debt levels. Among business groups, earnings management in pyramidal groups is less sensitive to debt levels. We also find that the debt‐abnormal accrual curve becomes smoother as group profitability increases when considering the non‐monotonic relationship between firm leverage and earnings management.     

Safety Transformation and the Structure of the Financial System

This paper studies how a financial system that is organized to efficiently create safe assets responds to macroeconomic shocks. Financial intermediaries face a cost of bearing risk, so they choose the least risky portfolio that backs their issuance of riskless deposits: a diversified pool of nonfinancial firms' debt. Nonfinancial firms choose their capital structure to exploit the resulting segmentation between debt and equity markets. Increased safe asset demand yields larger and riskier intermediaries and more levered firms. Quantitative easing reduces the size and riskiness of intermediaries and can decrease firm leverage, despite reducing borrowing costs at the zero lower bound.     

Corporate debt maturity in the MENA region: Does institutional quality matter?

We investigate corporate debt maturity structure in the MENA region and its firm and institutional determinants using a sample of 444 listed firms over the 2003–2011 period, or 3717 firm-year observations. We find a very limited use of long-term debt by MENA firms; long-term debt represents only 3.41% of the typical MENA firm's total debt, which is much less than what is reported in prior literature on other parts of the world. Consistent with the predictions of debt maturity theories and prior empirical findings, we find that leverage, firm size, and asset tangibility are positively associated with the use of more long-term debt while firms facing a higher risk of default tend to use more short-term debt. In addition, we find that better quality institutions lead to the use of more long-term debt in MENA. Specifically, stronger rule of law, better regulatory effectiveness, better legal protection of creditors, and more developed financial intermediaries are associated with greater use of long-term borrowing by MENA firms. Our findings have important policy implications as they illuminate the path toward needed reforms that would enhance MENA firms' access to long-term debt, which may ultimately result in more private investment and jobs.     

Growth Opportunities and the Choice of Leverage, Debt Maturity, and Covenants

We investigate the effect of growth opportunities in a firm's investment opportunity set on its joint choice of leverage, debt maturity, and covenants. Using a database that contains detailed debt covenant information, we provide large‐sample evidence of the incidence of covenants in public debt and construct firm‐level indices of bondholder covenant protection. We find that covenant protection is increasing in growth opportunities, debt maturity, and leverage. We also document that the negative relation between leverage and growth opportunities is significantly attenuated by covenant protection, suggesting that covenants can mitigate the agency costs of debt for high growth firms.     

The influence of firm- and manager-specific characteristics on the structure of executive compensation

We analyze the influence of firm and managerial characteristics on executive compensation. Consistent with theory, we find monitoring difficulties result in greater use of options while CEO and blockholder ownership result in less. Risky investment is positively related to options and negatively related to cash bonus and restricted stock, suggesting that firms use options to encourage managers to take risks. We find a negative (positive) relation between options and leverage (convertible debt) consistent with minimizing the agency costs of debt. Finally, we provide new evidence on managerial horizon and incentives, documenting a concave relation between cash bonus and CEO age.