Capital structure decisions: which factors are reliably important?

This paper examines the relative importance of many factors in the capital structure decisions of publicly traded American firms from 1950 to 2003. The most reliable factors for explaining market leverage are: median industry leverage (+ effect on leverage), market-to-book assets ratio (-), tangibility (+), profits (-), log of assets (+), and expected inflation (+). In addition, we find that dividend-paying firms tend to have lower leverage. When considering book leverage, somewhat similar effects are found. However, for book leverage, the impact of firm size, the market-to-book ratio, and the effect of inflation are not reliable. The empirical evidence seems reasonably consistent with some versions of the trade-off theory of capital structure.

**********

When corporations decide on the use of debt finance, they are reallocating some expected future cash flows away from equity claimants in exchange for cash up front. The factors that drive this decision remain elusive despite a vast theoretical literature and decades of empirical tests. This stems in part from the fact that many of the empirical studies are aimed at providing support for a particular theory. The amount of evidence is large, and so it is often all too easy to provide some empirical support for almost any idea. This is fine for a given paper but more problematic for the overall development of our understanding of capital structure decisions. As a result, in recent decades the literature has not had a solid empirical basis to distinguish the strengths and the weaknesses of the main theories.

Which theories shall we take seriously? Naturally, opinions differ. Many theories of capital structure have been proposed. But only a few seem to have many advocates. Notably, most corporate finance textbooks point to the "trade-off theory" in which taxation and deadweight bankruptcy costs are key. Myers (1984) proposed the "pecking order theory" in which there is a financing hierarchy of retained earnings, debt, and then equity. Recently, the idea that firms engage in "market timing" has become popular. Finally, agency theory lurks in the background of much theoretical discussion. Agency concerns are often lumped into the trade-off framework broadly interpreted.

Advocates of these models frequently point to empirical evidence to support their preferred theory. Often reference is made to the survey by Harris and Raviv (1991) or to the empirical study by Titman and Wessels (1988). (1) These two classic papers illustrate a serious empirical problem. They disagree over basic facts.

According to Harris and Raviv (1991, p. 334), the available studies "generally agree that leverage increases with fixed assets, nondebt tax shields, growth opportunities, and firm size and decreases with volatility, advertising expenditures, research and development expenditures, bankruptcy probability, profitability and uniqueness of the product." However, Titman and Wessels (1988, p. 17) find that their "results do not provide support for an effect on debt ratios arising from nondebt tax shields, volatility, collateral value, or future growth." Consequently, advocates of particular theories are offered a choice of diametrically opposing well-known summaries of "what we all know" from the previous literature. Clearly this is unsatisfactory, and this study aims to help resolve this empirical problem.

This paper contributes to our understanding of capital structure in several ways. First, starting with a long list of factors from the prior literature, we examine which factors are reliably signed, and reliably important, for predicting leverage. Second, it is likely that patterns of corporate financing decisions have changed over the decades. During the 1980s, many US firms took on extra leverage apparently due to pressure from the market for corporate control. Starting in the 1990s, more small firms made use of publicly traded equity. It is therefore important to examine the changes over time. Finally, it has been argued that different theories apply to firms under different circumstances. (2) To address this serious concern, the effect of conditioning on firm circumstances is studied.