Proactive Leverage Increases and The Value of Financial Flexibility

Traditional tradeoff models of corporate capital structure, although still featured prominently in finance textbooks and widely accepted by practitioners, have been criticized by financial economists for doing a poor job of explaining observed debt ratios. Moreover, the observed ratios are far less stable than what would be predicted by the standard tradeoff models. In a study published several years ago in the Review of Financial Studies, the authors of this article aimed to shed more light on the underlying forces governing capital structure decisions by analyzing a set of major changes in capital structure in which companies initiated large increases in leverage through substantial new borrowings. They then attempted to explain why these companies chose to increase leverage and how their capital structures changed during the years after the large debt issues. As summarized in this article, the authors' findings indicate, first of all, that the large debt financings were used primarily to fund major corporate investments—and not, for example, to make large distributions to shareholders. And the changes in leverage ratios that came after the debt offerings were driven far more by the evolution of the companies' realized cash flows and their investment opportunities than by deliberate or decisive attempts to rebalance their capital structures toward a stationary target. In fact, many of the companies chose to take on even more debt when faced with cash‐flow deficits, despite operating with leverage that was already well above any reasonable estimate of their estimated target leverage. At the same time, companies that generated financial surpluses used them to reduce debt, even when their leverage had fallen well below their estimated targets. Taken as a whole, the findings of the authors' study support the idea that unused debt capacity represents an important source of financial flexibility, and that preserving such flexibility—and making use of it when valuable investment opportunities materialize—may well be the critical missing link in connecting capital structure theory with observed corporate behavior.     

Capital Structure Instability

This article summarizes the evidence from the authors’ recent study published in the Journal of Finance that documented the extent of the variation in the capital structures of individual public companies over long time horizons. It also reports the results of an exploratory investigation into the sources of variation over time in leverage ratios—an investigation that included case analyses of leverage instability at 24 U.S. companies that were included in the Dow Jones Industrial Average at some point in their histories. The main finding of the authors’ study is that substantial instability in leverage has been the norm at publicly held nonfinancial companies. “Episodic” cases of leverage stability were observed from time to time, but they were the exception, not the rule. Such cases almost always involved companies with low leverage ratios, and they invariably proved to be short‐lived, rarely exceeding a decade or two. Leverage was found to be “sticky” during periods lasting just a few years, but a company's currently high (or low) leverage became an increasingly poor predictor of whether its future leverage would be high (or low) as the amount of time between leverage observations lengthened. When attempting to explain companyspecific changes in leverage after extended periods of stability, the authors found a strong connection with company expansion and investment. At the same time, they found no systematic relations between company‐specific leverage changes and changes in industry leverage, company profitability, or other determinants of leverage that have been emphasized in previous academic studies. The authors' case analyses reinforced their finding that capital structure changes were often linked to the funding of company expansions, but such changes were also sometimes designed to support established payout policies while preserving financing flexibility.     

THE CAPITAL STRUCTURE PUZZLE: ANOTHER LOOK AT THE EVIDENCE

Since the formulation of the M & M irrelevance propositions 40 years ago, financial economists have been debating whether there is such a thing as optimal capital structure—a proportion of debt to equity that maximizes current firm value. Some finance scholars have followed M & M by arguing that both capital structure and dividend policy are largely “irrelevant” in the sense that they have no significant, predictable effects on corporate market values. Another school of thought holds that corporate financing choices reflect an attempt by corporate managers to balance the tax shields and disciplinary benefits of greater debt against the increased probability and costs of financial distress. Yet another theory says that companies do not have capital structure targets, but instead follow a financial pecking order in which retained earnings are preferred to outside financing, and debt is preferred to equity when outside funding is required. In reviewing the evidence that has accumulated since M & M, the authors argue that taxes, bankruptcy (and other “contracting”) costs, and information costs (the main factor in the pecking order theory) all appear to play an important role in corporate financing decisions. While much if not most of the evidence is consistent with the argument that companies set target leverage ratios, there is also considerable support for the pecking order theory's contention that firms are willing to deviate widely from their targets for long periods of time. According to the authors, the key to reconciling the different theories—and thus to solving the capital structure puzzle—lies in achieving a better understanding of the relation between corporate financing stocks (leverage ratios) and flows (specific choices between debt and equity). Even if companies have target leverage ratios, there will be an optimal deviation from those targets—one that will depend on the transactions and information costs associated with adjusting back to the target relative to the costs of deviating from the target. As the authors argue in closing, a complete theory of capital structure must take account of these adjustment costs and how they affect expected deviations from the target.     

Strategic Financial Management: Lessons from Seasoned Equity Offerings

Each of today's three dominant academic theories of capital structure has trouble explaining the financing behavior of companies that have seasoned equity offerings (SEOs). In conflict with the tradeoff theory, the authors’ recent studies of some 7,000 SEOs by U.S. industrial companies over the period 1970‐2017 notes that the vast majority of them—on the order of 80%—had the effect of moving the companies away from, rather than toward, their target leverage ratios. Inconsistent with the pecking‐order theory, SEO issuers have tended to be financially healthy companies with low leverage and considerable unused debt capacity. And at odds with the market‐timing theory, SEOs appear to be driven more by the capital requirements associated with large investment projects than by favorable market conditions. The authors’ findings also show that, in the years following their stock offerings, the SEO companies tend to issue one or more debt offerings, which have the effect of raising their leverage back toward their targets. Whereas each of the three theories assumes some degree of shortsightedness among financial managers, the authors’ findings suggest that long‐run‐value‐maximizing CFOs manage their capital structures strategically as opposed to opportunistically. They consider the company's current leverage in relation to its longer‐run target, its investment opportunities and long‐term capital requirements, and the costs and benefits of alternative sequences of financing transactions. This framework, which the authors call strategic financial management, aims to provide if not a unifying, then a more integrated, explanation—one that draws on each of the three main theories to provide a more convincing account of the financing and leverage decisions of SEO issuers.     

Disentangling Sentiment from Cyclicality in Firm Capital Structure

This study examines the relationship between capital structure choices and investor and managerial sentiment, finding that periods of positive sentiment are associated with reduced leverage within firms. We focus on the cyclicality of leverage using non-orthogonalized sentiment indices and find a strong negative relationship. Leverage, therefore, appears countercyclical, implying that the decision to take on debt is a consequence of either Admati et al.'s (2018) ratchet effect or a managerial attempt to time the market. Our findings lead us to question some fundamental capital structure theories, namely, trade-off (Kraus and Litzenberger, 1973), and Hackbarth's (2008) managerial traits theory. Instead, we favour the idea that leverage is a consequence of countercyclical market timing behaviour.     

The Capital Structure Puzzle: Another Look at the Evidence

Since the formulation of the Miller and Modigliani propositions over 60 years ago, financial economists have been debating whether there is such a thing as an optimal capital structure—a proportion of debt to equity that can be expected to maximize long‐run shareholder value. Some finance scholars have followed M&M in arguing that both capital structure and dividend policy are irrelevant in the sense of having no significant, predictable effects on corporate market values. Another school of thought holds that corporate financing choices reflect an attempt by corporate managers to balance the tax shields and disciplinary benefits of more debt against the costs of financial distress. Still another theory says that companies do not have capital structure targets, but instead follow a financial pecking order in which retained earnings are generally preferred to outside financing, and debt is preferred to equity when outside funding is required. In reviewing the evidence that has accumulated since M&M, the authors argue that taxes, bankruptcy and other contracting costs, and information costs all appear to play important roles in corporate financing decisions. While much, if not most, of the evidence is consistent with the idea that companies set target leverage ratios, there is also considerable support for the pecking order theory's contention that managements are willing to deviate widely from their targets for long periods of time. According to the authors, the key to reconciling the different theories—and thus to solving the capital structure puzzle—lies in achieving a better understanding of the relation between corporate financing stocks (that is, total amounts of debt and equity) and flows (which security to issue at a particular time). Even when companies have leverage targets, it can make sense to deviate from those targets depending on the costs associated with moving back toward the target. And as the authors argue in closing, a complete theory of capital structure must take account of these adjustment costs and how they affect expected deviations from the targets.     

THE CAPITAL STRUCTURE CHOICE: NEW EVIDENCE FOR A DYNAMIC TRADEOFF MODEL

Most academic insights about corporate capital structure decisions come from models that focus on the trade-off between the tax benefits and financial distress costs of debt financing. But empirical tests of corporate capital structure indicate that actual debt ratios are considerably different from those predicted by the models, casting doubt on whether most companies have leverage targets at all. In particular, there is considerable evidence that corporate leverage ratios reflect in large part the tendency of profitable companies to use their excess cash flow to pay down debt, while unprofitable companies build up higher leverage ratios. Such behavior is consistent with a competing theory of capital structure known as the "pecking order" model, in which management's main objectives are to preserve financing flexibility and avoid issuing equity.
The results of the authors' recent study suggest that although past profits are an important predictor of observed debt ratios at any given time, companies nevertheless often make financing and stock repurchase decisions designed to offset the effects of past profitability and move their debt ratios toward their target capital structures. This evidence provides support for a compromise theory called the dynamic tradeoff model, which says that although companies often deviate from their leverage targets, over the longer run they take measures to close the gap between their actual and targeted leverage ratios.     

The firm''s leverage-cash flow relationship

Two separate strands of the literature on capital structure under asymmetric information consider the relationship between a firm's financial leverage and cash flow. Signalling theory suggests a positive relationship, while pecking order behavior implies a negative relationship. These contrasting theoretical implications appear contradictory. However, both are supported in different bodies of empirical literature. Leverage-changing event studies tend to support a positive relationship while cross-sectional studies typically reveal a negative relationship. This paper proposes that the appropriate pecking order relationship is contemporaneous — between current leverage and current cash flow, while the relevant signalling relationship is intertemporal-between current leverage and future cash flow. A dynamic simultaneous equations model is built which allows the firm's leverage, cash flow, and risk to interact jointly in the same period, as well as across time. Empirical results reveal that, in the same time period, leverage and cash flow tend to be negatively related, while across time leverage is positively related to future cash flow. Thus the apparent contradictions in the theoretical and empirical literature may be reconciled by considering both the contemporaneous and dynamic aspects of the firm's leverage/cash flow relationship.     

Why Study Large Projects? An Introduction to Research on Project Finance

Despite the fact that more than $200 billion of capital investment was financed through project companies in 2001, an amount that grew at a compound annual rate of almost 20% during the 1990s, there has been very little academic research on project finance. The purpose of this article is to explain why project finance in general and why large projects in particular merit separate academic research and instruction. In short, there are significant opportunities to study the relationship among structural attributes (i.e., high leverage, contractual details, and concentrated equity ownership), managerial incentives, and asset values, as well as improve current practice in this rapidly growing field of finance.     

Leverage,executive incentives and corporate governance

This paper analyses the effect of executive incentives and internal governance on capital structure. Using a large sample of non‐financial US‐listed firms over the period 1999–2005, it is found that managers have different attitudes towards leverage when offered different incentive schemes; leverage initially decreases in bonuses and stock incentives and then increases in these incentives after a certain incentive level, suggesting the existence of the entrenchment–alignment effects under these incentive schemes. In contrast, leverage initially increases in option incentives and then decreases after a certain option incentive level. When all of these incentive schemes are combined together into a single incentive package, the entrenchment–alignment effects prevail. It is also found that leverage increases in internal governance and managers behave differently under different governance regimes such that the entrenchment–alignment effects prevail under weak governance firms, whereas the alignment–entrenchment effects prevail under strong governance firms. The results also suggest that managers’ target leverage ratio is less than the one predicted by theory or preferred by firm shareholders.     

中国上市公司融资选择的市场时机效应——基于股票换手率和股票收益的实证检验

自从市场时机资本结构理论提出以来，国内外学者从理论的解释能力和实用性等方面对这一新兴融资决策理论进行了大量研究，并得出许多有意义的结论。然而目前的实证检验主要基于市值账面比（M／B）指标作为市场时机代理变量，这一指标引起学者们很大争议，研究结论缺乏可靠性。本文根据我国资本市场实际特征选择股票换手率作为市场时机代理变量，实证检验了市场时机与外部融资方式选择的关系，同时引入股票收益变量检验市场时机对资本结构动态变动的综合影响。研究结论显示，换手率在企业权益融资中具有重要作用，换手率较高时企业选择发行更多的股权融资，股票换手率和股票收益均对资本结构变动具有显著的负向影响。这表明我国上市公司确实存在着融资选择的市场时机效应。     

How Investment Opportunities Affect Optimal Capital Structure

This article addresses the question of how competition for investments among companies in a certain industry affects their capital structure. The authors develop a new modelling framework that simulates financial variables of a set of firms in a given sector, and uses the framework to analyze how such firms compete for new investments. The leverage of companies affects their flexibility to react to and take advantage of investment opportunities, and the authors show how such flexibility can be optimized to maximize the firm’s growth. As an illustration, they apply the model to a set of European airlines and global pharmaceutical companies. The novelty introduced by this paper is the explicit modelling of the interaction between several companies. The literature on optimal capital structure focuses on individual companies optimizing their capital structure in a world in which the actions of their competitors are exogenous. The authors’ results show how to incorporate the competitive position of the firm as well as the availability of investment opportunities into the capital structure decison.     

电力行业上市公司的财务杠杆效应分析——基于2006-2009年的经验数据

我国上市公司的资本结构普遍不合理,并没有充分发挥债务融资的财务杠杆效应。本文以我国电力行业四家上市公司作为实证样本,基于其财务杠杆效应的利用现状,通过多元回归分析揭示了净资产收益率与负债权益比、债务利息率、息税前利润率等影响因素的相关性及显著性,从而为电力行业上市公司财务杠杆效应的有效利用提供理论指导与实务借鉴。     

The Leveraging of Corporate America: A Long‐Run Perspective on Changes in Capital Structure

In a study published recently in the Journal of Financial Economics, the authors of this article documented a substantial increase in the use of debt financing by U.S. companies over the past century. From 1920 until the mid‐1940s, the aggregate leverage of unregulated U.S. companies was low and stable, with the average debt‐to‐capital ratio staying within the narrow range of 10% to 15%. But during the next 25 years, the use of debt by U.S. companies more than doubled, rising to 35% of total capital. And since 1970, aggregate leverage has remained above 35%, peaking at 47% in 1992. Moreover, this pattern has been observed in companies of all sizes and operating in all unregulated sectors. Changes in the characteristics of U.S. public companies during this period provide little help in explaining the increase in corporate leverage. For example, the displacement of tangible by intangible assets in many sectors of the U.S. economy during the past 50 years would have led most economists to predict, holding all other things equal, a reduction rather than an increase in aggregate corporate leverage. Instead, according to the authors' findings, the main contributors to the increases in U.S. corporate leverage since the 1940s have been external changes, including increases in corporate income tax rates, the development of financial markets and intermediaries, and the reduction in government borrowing in the decades following World War II. The authors' analysis also identifies these last two changes—the development of financial markets, including the rise of institutional investors and shareholder activism, and the post‐War reduction in government debt—as having played the biggest roles in the leveraging of corporate America.     

Ultimate Ownership and Adjustment Speed Toward Target Capital Structures: Evidence from China

We investigate whether ultimate ownership affects firms’ adjustment speed toward target capital structures for Chinese publicly listed companies over the period 1999–2009. We divide our sample into state-owned enterprises (SOEs) and non-SOEs according to their ultimate ownership. We find that SOEs have higher leverage ratios and slower adjustment speeds toward target capital structures. Our results are consistent with the trade-off theory, implying that the political resources of SOEs can lead to a higher persistence and slower leverage adjustment speeds in comparison to non-SOEs. Finally, our results also raise a question: Why do Chinese companies adjust their capital structure so fast?     

A macroeconomic approach to corporate capital structure

The cross-sectional distribution of corporate capital structure and its macroeconomic implications are underexplored research areas. This paper embeds a dynamic trade-off theory of firm financing into a general equilibrium model with firm dynamics. I find that the stationary equilibrium replicates fairly well the distribution of leverage as well as the relationship between leverage, size and profitability. The counterfactual experiment points out relatively small effects of tax benefits on corporate capital structure. It also implies that the effects of the default cost on macroeconomic variables are almost negligible under endogenous capital structure choice.     

How does owners’ exposure to idiosyncratic risk influence the capital structure of private companies?

This paper identifies the owner's exposure to idiosyncratic risk as an important determinant of the demand for loans and the capital structure of private companies. The analysis is based on a sample of small and medium-sized companies from the United States. The exposure to idiosyncratic risk is approximated by the share of personal net worth invested in one company (SNWI). Exposure to idiosyncratic risk increases the cost of equity capital, since higher equity returns are required as compensation. This therefore makes bank financing more attractive. We find that SNWI increases both the demand for new bank loans and leverage substantially.     

THE BALANCED CAPITAL STRUCTURE

At leading companies, financial executives are becoming business partners rather than just scorekeepers. In this environment, capital structure can be a source of competitive advantage, and financial strategy issues are critical: Should your company buy back shares or issue stock, grow internally or join the M & A boom, issue fixed-rate debt or stay floating? These decisions must be addressed one company at a time, balancing the competing priorities of cost, risk, and flexibility. The most important issue, target leverage, depends on the company's desired risk profile, growth plans, and debt cost considerations. But market conditions are also very important: Can the company access the equity market? How will a repurchase announcement be interpreted? Market conditions also affect the raising of debt capital. Rather than maintaining a constant mix of fixed- to floating-rate debt, companies should shift the mix during high- or low-yield environments. Many other financing issues will effectively be decided by market convention. For example, meeting a company's needs with respect to seniority, maturity structure, call flexibility, and financial covenants is often accomplished simply by choosing the market that most closely matches the firm's cost and risk preferences.     

Financial Flexibility,Investment Ability,and Firm Value: Evidence from Firms with Spare Debt Capacity

We document, for the first time, that a conservative leverage policy directed at maintaining financial flexibility can enhance investment ability. Our analysis reveals that following a period of low leverage, firms make larger capital expenditures and increase abnormal investment. We find that these new investments are financed through new issues of debt. The impact of financial flexibility is both statistically significant and economically sizable. Further, long-run performance tests reveal that financially flexible firms not only invest more but also invest better. Our results are consistent with the view that financial flexibility in the form of untapped reserves of borrowing power is a crucial missing link in capital structure theory.