Common Flaws in Empirical Capital Structure Research

Ivo Welch Brown University and NBER October 2, 2006

Abstract This paper critiques three issues that commonly arise in empirical capital structure research. 1. Capital Structure Proxies: The nancial-debt-to-asset ratio is awed as a measure of leverage, because the converse of nancial debt is not equity. Depending on specication, the debt-to-asset ratio can explain only about 10-50% of the variation in the equity-to-asset ratio. This is because most of the opposite of the nancial-debt-to-asset ratio is the non-nancial-liabilities -to-asset ratio. This problem is easy to remedy researchers should use a debt-to-capital ratio or a liabilities-to-asset ratio. The converse of either is an equity ratio. 2. Non-linearity: The intrinsic non-linearity of leverage ratios can render standard linear regressions even with perfect independent variables seemingly powerless. Fortunately, researchers can easily test whether variables have a linear or non-linear inuence on equity value changes, debt value changes, or leverage ratios. 3. Selection Issues: There are large survivorship biases in the CRSP/Compustat data bases. About 10% of rms appear and 10% disappear in a single year. These birth and death rates are themselves functions of capital structure and other rm characteristics. This selection makes studying long-term capital structure changes dicult. Unfortunately, this problem is dicult to remedy. The paper does not claim that these three issues drive results in the existing literature. It does however claim that they are not so small as to allow ignoring them a priori. The paper also claries some theoretical issues, most of which are not new, but which are suciently often muddled that a clarication is useful. First the paper distinguishes between capital structure mechanisms and causes. Second, when it comes to causes, it claries that there is no dichotomy between the pecking order theory and the trade-o theory. A pecking order arises in a trade-o theory in which issuing more junior securities is relatively more expensive, or possibly prohibitively expensive. A pecking order is not synonymous with adverse selection, nancial slack, or a nancing pyramid, either.

This draft is early. Comments are welcome.

This paper arose out of an NBER discussion of Lemmon, Roberts, and Zender (2006). I thank Malcolm Baker, Long Chen, Michael Roberts, Sheridan Titman, and Jerey Wurgler for comments.

The principal phenomenon that the capital structure literature tries to explain is variation in corporate indebtedness. (Closely related literatures are the payout distribution and repurchase literatures, and are often also grouped with the capital structure literature.) The capital structure literature is interested both in the cross-section of capital structurewhy do some rms have high ratios today and others do notand in the time-serieshow do capital structures evolve. Although the goal of the literature is straightforward, there are many variations in the details. For example, dierent papers interpret dierent theories and ndings dierently, seek to explain dierent variables, and use alternative specications This paper presents three simple but common pitfalls that empiricists should be aware of. 1. Capital Structure Proxies: The nancial-debt-to-asset ratio is awed as a measure of leverage, because the converse of nancial debt is not equity. Depending on specication, the debt-to-asset ratio can explain only about 10-50% of the variation in the equity-to-asset ratio. This is because most of the opposite of the nancial-debtto-asset ratio is the non-nancial-liabilities -to-asset ratio. This problem is easy to remedyresearchers should use a debt-to-capital ratio or a liabilities-to-asset ratio. The converse of either is an equity ratio. 2. Non-linearity: The intrinsic non-linearity of leverage ratios can render standard linear regressions even with perfect independent variables seemingly powerless. Fortunately, researchers can easily test whether variables have a linear or non-linear inuence on equity value changes, debt value changes, or leverage ratios. Some variables are particularly prone to exert linear inuences on leverage ratio constituents. For example, (retained) earnings and depreciation tend to inuence the book values of equity, market price changes tend to inuence market values of equity. Interest rate changes and payments tend to inuence the value of debt. It is a priori unclear whether the inuence of these variables (and variables strongly correlated with them) is linear or non-linear. 3. Selection Issues: There are large survivorship biases in the CRSP/Compustat data bases. About 10% of rms appear and 10% disappear in a single year. These birth and death rates are themselves functions of capital structure and other rm characteristics. This selection makes studying long-term capital structure changes dicult. Unfortunately, this problem is dicult to remedy. This paper does not show that these issues are responsible for results in the existing literature. Indeed, it could be that if research designs take them into account, previously 2

reported empirical regularities would improve in signicance. (They could also pull in dierent directions, and by happenstance cancel one another.) However, we do not know this a priori. The paper does show that these three issues are important. It is unsettling that the empirical literature today relies primarily on capital structure studies that suer from one or more of these three issues. Thus, it would not only be desirable for future studies taking these issues into account, but also to conrm the results of earlier studies.1 The paper also makes some other empirical specication and theoretical interpretation observations. It distinguishes between mechanisms and deeper causes. The two theories most prominently perceived as deeper explanations are the pecking order theory and the trade-o theory. Although most of the insights themselves are not novel, they are suciently frequently left ambiguous to make it worthwhile to lay them out clearly. The main point is that a pecking order arises in a trade-o theory, in which issuing more junior securities is relatively more expensive, or possibly prohibitively expensive. The pecking-order and trade-o theories are not converse, but (normally) facets of the same theory. It is also important to recognize that the pecking order is not synonymous with adverse selection, nancial slack, or a nancing pyramid. Finally, this paper oers a speculative view on where future progress in our understanding of capital structure could come from.

Issues With the Financial Debt To Asset Ratios

Although other leverage measures are also in common use, the single most common debtratio variable in this literature is nancial debt (often the sum of long-term debt and debt in current liabilities, Compustat #9 plus #34) divided by assets (Compustat #6). The assets are usually quoted in book value, though sometimes translated into market value. This is accomplished by subtracting o the book value of equity and adding back the market value of equity.2 The authors normal desired interpretation is that this nancial debt-to-asset ratio is a measure of leverage, the converse of which are presumably more junior nancial
1 To a referee (not for publication): I originally considered replicating some earlier studies. Ultimately, I decided this would be counterproductive. I do not wish to pick on one particular study. Showing that these three issues are problems for one study would say little about whether or not they are problems for other studies. Thus, I believe it is more productive to instead quantify how important the three issues are, as my current paper does. 2 The majority of paper in this literature use such a debt-to-asset ratio. This includes such classic papers as, for example, Rajan and Zingales (1995), Shyam-Sunder and Myers (1999), Baker and Wurgler (2002), and Graham (2003). Note that these papers use debt-to-asset ratios at least in some of their specications, but they often do entertain other measures, too. (The reader can easily conrm from current nance journals that the debt-to-asset ratio remains the most common dependent variable in this literature today.)

securities, such as an equity-to-asset ratio. Increases in debt-to-asset ratios are presumably leverage increases, and equivalent to decreases in the equity-to-asset ratio. However, this interpretation is awed, because the opposite of nancial debt is not equity. Instead, the opposite of nancial debt are non-nancial liabilities plus equity. Assets = Financial Debt + Non-Financial Liabilities + Equity .

Figure 1 shows the components of liabilities. The liabilities that are not nancial debt are Minority Interest (Compustat #38), Deferred Tax and ITC (#35), Other Liabilities (#75), Other Current Liabilities (#72), Notes Payable (#206), Accounts Payable (#70), and Income Tax Payable (#71). These liabilities are taken on in the process of operating and adding to the rms assets, just as an inow of debt equity would add to the rms assets. Any payment of either nancial or non-nancial liabilities is made from pre-tax income. Moreover, it is clear that equity is junior both to nancial debt and to non-nancial liabilities. In contrast, non-nancial liabilities can be of higher, equal, or lower priority than nancial debt. An increase in one that is accompanied by a decrease in the other can therefore not necessarily be interpreted as a change in leverage. This issue manifests itself in the empirical literature in that the opposite of the debt-to-asset ratio is not merely an equity-to-asset ratio, but the sum of the non-nancial liability-to-asset ratio and the equity-to-asset ratio. Nevertheless, it would be reasonable to rely on the nancial-debt-to-asset ratio if it were just slightly awedif the non-nancial liabilities-toasset ratio were relatively insignicant. In this case, the nancial debt-to-asset ratios can be interpreted as close enough to the converse of equity-to-asset ratios (The share of equity as a fraction of either assets or nancial capital is an unambiguous measure of leverage.) Table 2 shows the mean sizes of the three components of assets. It does not appear as if non-nancial liabilities are small. On the contrary, they tend to be larger than either nancial debt or eqity values. Among the largest 500 rms, relying on the book value of equity, the average nancial-debt-to-asset ratio is about one-quarter, the average equity-toasset ratio is about one-quarter, leaving one-half to the non-nancial liabilities. Expanding this to 3,000 rms, non-nancial liabilities are still typically about 40% of assets. The same applies if equity and assets are measured in market value rather than book value. (Not reported, there is no strong trend in year-to-year changes of debt-to-asset, equity-to-asset, or non-nancial liability-asset ratios.) It could still be that non-nancial liabilities are unimportant, either in levels or in changes, if they remain stable across rms (for level regressions), or if they do not change over time

Figure 1: Components of Total Liabilities

The number in parentheses are the Compustat data item.

(for dierence regressions). Thus, Table 2 reports the results of the following estimated regression:
Equity Assets = 0 + Debt 1 Financial Assets + Noise . (1)

Because the LHS dependent variable is an unambiguous ratio measure of leverage (equity is junior to both nancial and non-nancial liabilities), these regressions can be interpreted as relating the commonly-used leverage ratio (RHS) to the correct leverage ratio. If 1 1, then rms do not substitute other liabilities for nancial debt on average. If the R 2 of the regression is close to 100%, then the omission of non-nancial liabilities is inconsequential. (It is the R 2 s of non-nancial liabilities plus liabilities that must add up to 1 in explaining equity ratios, not the correlations, so the reader should think in terms of R 2 s.) In levels, rms with higher debt-to-asset ratios can then be viewed as more levered. In changes, increases in the nancial-debt-to-asset ratio can then be viewed as moving the rm towards a capital structure with more senior and fewer junior claims. The regression results in Table 2 convey a similar message as the means in Table 1. In the cross-sectional regressions, among the largest 500 rms (which comprise most of the 5

Table 1: Means of Financial Asset-Normalized Financial Debt, Non-Financial Liabilities, and Equities
Market or Book Value BV MV BV Minimum Inclusion 8 8 0.2 0.2 Means NFL/A E/A 48% 25% 47% 26% 42% 35% 43% 23% 42% 35% 43% 23%

Average Year-by-Year Mean Pooled Mean Average Year-by-Year Mean Pooled Mean Average Year-by-Year Mean Pooled Mean

D/A 27% 27% 23% 34% 23% 34%

N 505 11,625 505 11,625 2,905 66,826

Explanation: D/A are nancial liabilities (Compustat D = #9 + #34) divided by assets (A = #6). Market values subtract the book value of equity (E = #60) and add back the market value (#199#54). NFL are the remaining non-nancial liabilities. All ratios were truncated at 0 and 1. For a rm-year to be included, it had to have had market and book levels of assets greater than x times the S&P500 level the year prior to inclusion, where x is either 8 (for about 500 rms) or 0.2 (for about 3,000 rms). For example, in the top four rows, a rm-year was included in 2000 if its book value of assets was at least 8 $1.469 = $11, 752 billion at the end of 1999, because the S&P in 1999 nished at 1,469. Interpretation: Non-nancial liabilities are not inconsequentially small.

markets capitalization, and thus would dominate any value-weighted study), there is little correlation between nancial-debt-to-asset and equity-to-asset ratios in levels. In book values, the R 2 is below 5%; in market values, it is around 10%. It follows that most of the cross-sectional heterogeneity in the true leverage ratio (i.e., one minus the dependent variable, the equity-to-asset ratio) is due to non-nancial liabilities. With explanatory power this low, any regression among these rms using the debt-to-asset ratio suers from a pure error problem, more than it suers from an error-in-variables problem. One cannot simply equate large rms with high nancial-debt-to-asset ratios as rms that are highly levered. In a broader set of 3,000 rms, depending on whether a Fama-MacBeth type or pooled regression is used, around 34% to 43% of the level heterogeneity in leverage ratios is due to variation in nancial debt-to-asset ratios. Thus, two thirds of the cross-sectional heterogeneity in equity-to-asset ratios comes from the non-nancial liabilities. Non-nancial liabilities have a stronger inuence on true leverage than the nancial debt variable that is so commonly used. In changes, among the largest 500 rms, less than one third of the variation in equityto-asset ratio changes is explained by nancial-debt-to-asset ratio changes. Therefore, about three-quarters of the variation in the true leverage ratio changes must come from 6

Table 2: Financial Debt-To-Asset and Financial Equity-To-Asset Ratios In Levels E/A = 0 + 1 D/A In Dierences E/A = 0 + 1 D/A

Around 500 Firm (V Factor 8), In Book Values Coef 1 0.08 0.08 0.07 0.06 0.06 0.13 0.19 0.11 0.17 0.08 0.07 0.09 0.12 0.16 0.16 0.17 0.25 0.18 0.22 0.30 0.41 0.34 0.28 0.16 0.17 R2 0.00 0.00 0.00 0.00 0.00 0.01 0.03 0.01 0.03 0.01 0.01 0.01 0.02 0.02 0.03 0.03 0.06 0.04 0.06 0.10 0.17 0.09 0.07 0.04 0.03 N 662 636 610 633 566 541 575 557 509 566 504 501 492 535 457 432 371 329 315 365 450 573 446 505 11,625 Coef 1 0.48 0.36 0.35 0.35 0.61 0.67 0.73 0.67 0.51 0.31 0.66 0.39 0.11 0.39 0.45 0.53 0.54 0.39 0.43 0.51 0.73 0.53 0.34 0.48 0.52 R2 0.36 0.24 0.13 0.14 0.47 0.46 0.60 0.45 0.51 0.04 0.50 0.11 0.01 0.18 0.26 0.39 0.37 0.19 0.24 0.34 0.45 0.14 0.17 0.29 0.27 N 662 636 610 633 566 541 575 557 509 566 504 501 492 535 457 432 371 329 315 365 450 573 446 505 11,625

1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 FM Pooled

1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 FM Pooled

3,000 Firms (V Factor 0.2), In Book Values Coef 1 0.71 0.87 R2 0.34 0.43 N 2,905 66,826 Coef 1 0.85 -1.26 R2 0.49 0.62 N 2,905 66,826

FM Pooled

FM Pooled

500 Firms (V Factor 8), Market Values of Equity and Assets Coef 1 0.43 0.42 R2 0.10 0.08 N 505 11,625 Coef 1 0.71 0.75 R2 0.39 0.41 N 505 11,625

FM Pooled

FM Pooled

Explanation: The regression explains the equity-to-asset ratio (book-value in the top two panels, market-value in the bottom panel) with the corresponding nancial debt-to-asset ratio. Inclusion criteria and truncations are explained in Table 1. FM (Fama-Macbeth) is the mean of the annual coecients. Interpretation: A large part of the variation in equity-to-asset ratios comes from changes in the non-nancial liabilities-asset ratio, and not from changes in the nancial-debt-to-asset ratio. Put dierently, a large part of changes in nancial leverage is picked up (undone) by changes in non-nancial liabilities.

non-nancial liability ratio changes. In other words, nancial-debt-to-asset ratio changes are not even the primary driver of leverage ratio changes, non-nancial debt-to-asset ratio changes are. In a broader subset of 3,000 rms, the relation between debt-to-asset and equity-to-asset ratios becomes stronger, but it is not overwhelming, either. Non-nancial liability ratio changes continue to explain about half of the equity-to-asset (true leverage ratio) changes. It is not necessarily comforting that the correlation between true and used leverage ratios is higher when more rms are included. (Most existing studies would include a sample akin to the broader set.) Aside from the fact that the explanatory power still often remains below 50%, the fact that dierent rms have dierent relationships between nancial debt and equity on the one hand, and non-nancial liabilities on the other hand, further advises caution: The proxy quality is not just simply noisy, but noisier for some specic rms with specic attributes (e.g., size) than it is for others. This will bias the coecients. Broader Implications: In existing studies, the use of a nancial-debt-to-asset ratio may have just added noise. For example, if a factor that inuences the nancial debt-to-asset ratio does not inuence the non-nancial liabilities-to-asset ratio, especially if does not do so dierentially across dierent types of rms, then the results would remain the same. The regressions would merely be less powerful. Nevertheless, we cannot know which existing results in the literature, if any, are sensitive to the leverage denition. Studies having used nancial debt-to-asset ratios may require reexamination and conrmation. Third variables hypothesized to drive the division between debt and equity could instead merely inuence the division of the rms liabilities between nancial and non-nancial ones. Fortunately, this problem is easy to correct. It is sensible to oer as a prescription for future research to avoid the nancial-debt-to-asset ratio. Instead, researchers should entertain only either 1. nancial debt divided by nancial capital (the sum of nancial debt plus nancial equity); 2. or total liabilities divided by total assets. (Other liabilities can include pension obligations, payables, etc., because they create an asset at the same time, just as issuing activity does.) Of course, these measures have dierent economic meaning, but they are internally consistent, in the sense that a higher measure implies a higher leverage. The reason is that the

converse of either indebtedness ratio is an equity ratio.3 A third alternative that would sort non-nancial liabilities into those that are of higher priority and those that are of lower priority than nancial debt seems generally not feasible. A fourth alternative would be use a measure based on ows, such as interest coverage, as a measure of debt burden. However, because operating cash ows can be negative and because they are strongly business-cycle dependent, and because interest payments can be zero (and some rms even report negative interest payments), such a measure is not easy to use, either. As a nal note, the problem that leverage is often misdened as a nancial-debt-to-asset ratio is not exclusive to the capital structure literature. The debt-to-asset ratio also often appears as an independent variable (rather than as the dependent variable) in other nancial literatures. In this case, such a debt-to-asset denition can cause a potentially equally serious error-in-variables problem. The measure is unlikely to measure well what the researcher originally had in mind.

II

Issues with the Econometric Specication: Non-Linearity and Changes in Leverage Ratios

Heterogeneity in capital ratios among dierent industries and types of rms is a wellknown empirical regularity. For example, Table 5 below shows that disproportionally many technology rms have no debt. This section shows that this heterogeneity complicates translating value changes into capital structure eects. The reason is that debt ratios are highly non-linear in their components, debt and equity. For example, consider the eect of a rm that doubles its equity value (either through net equity issuing or through a value change). If the rm was originally nanced 50-50 by debt and equity, it will now be nanced 33-67 by debt and equity. This rm would experience a decline in its debt-equity ratio. If it was nanced 0-100 by debt and equity instead, it will experience no change in its debt ratio.

I would also claim that the common use of book values rather than market values is a mistakebut which to use is already a well-known controversy. I know of no literature, other than the capital structure literature, in which researchers prefer a book value to a readily available market value. There are systematic cross-sectional dierences (e.g., in age and size) in how book-values relate to market-values. In this paper, I have used the book value only because I wanted to clarify that the issues critiqued are not due to the use of market-value based measures of leverage.

More Counterintuitive Illustration

Figure 2 illustrates yet another less intuitive aspect of the non-linearity. The rms base capital structure is xed at an equity value of $10 at the outset, and a debt value that is indicated by the value on the right of each graphed function. In the gure, there is no change in debt value, and there are zero other liabilities. The independent variable is the size of the equity value change (e.g., caused by an equity issue or a stock return). The dependent variable is the change in the equity/capital ratio (CER), dened as
CERt 1,t Et + Et 1,t Et . Dt + Et + Et 1,t Dt + Et (2)

Of course, the more common change in the capital leverage ratio (CLR) is CLRt 1,t

1 CERt 1,t . The gure shows that for rms which start out with no debt, an equity value change causes no leverage ratio change. The equity value change is progressively more eective in changing the capital structure ratio until the original debt reaches about D0 = (E0 + E) E0 = $24and then the eect of an equity value change on leverage ratio changes declines again.

The Standard Linear Research Design

This paper can illustrate how the non-linearity can matter in an empirical linear-estimation context. The empirical research hypothesis is that changes in debt and equity value change leverage-to-capital ratios. Of course, this relationship between these variables is a tautology to change leverage, it is precisely and only changes in debt and equity values that can matter. The specic research design now entertained will however use a more naive approach. The goal is to assess the quality of this standard linear model specication in the context of these perfect independent variables. 1. Dene the nancial capital as the sum of debt and equity,
Ct Et + Dt (3)

where E is the rms book equity (Compustat #60), and D is the sum of book nancial debt (long-term debt [Compustat #9] and debt in current liabilities [Compustat #34]). To keep the variance low, this uses the book value of equity rather than the market value of equity. 10

Figure 2: Non-Linearity

0.5 Change in Equity/Asset Ratio D0=$25 D0=$50 D0=$8

0.4

E0=$10

0.3

0.2

D0=$150 D0=$200 D0=$2

0.1 D0=$1 0.0 0 10 20 30 40 50 D0=$0

Change in Equity Value

This gure plots (E0 + E)/(D0 + E0 + E) E0 /(D0 + E0 ). The original equity value, E0 = $10. The original debt value, D0 , is indicated on the right. The total equity value change, E , is plotted on the y -axis.

2. Compute the change in the capital leverage ratio (CLR),

CLRt +1 Dt Dt +1 . Ct +1 Ct (4)

Except for the fact that the denominator is nancial capital rather than total assets, this variable is the most common dependent variable in the capital structure literature. 3. Compute the equity change (including issuing and value changes), normalized by the start-of-period capital,
Et +1 Et +1 Et , Ct Dt +1 Dt . Ct (5)

and do the same for debt,

Dt +1 (6)

As noted, these equity and debt change variables rely on ex-post knowledge of all changes in value. Thus, they are the best independent variables that an empiricist could ever hope to have. In a non-linear fashion, together with the starting capital

11

structure, these two changes can fully explain the change in the capital leverage ratio, because
CLRt +1 = Dt + Dt +1 Dt . Dt + Dt +1 + Et + Et +1 Dt + Et (7)

4. Instead of estimating the non-linear tautology, we now estimate the relationship between CLRt +1 as the dependent variable and equity changes Et +1 and debt changes Dt +1 as independent variables using a linear regression :
CLRt = 0 + 1 Dt + 2 Et + Noiset . (8)

Such a linearized reduced form is the most common method of estimation in the literature. The linearized theory would suggest a strong positive 1 coecient on Dt +1 (debt value increases should be associated with increases in leverage ratios), and a strong negative 2 coecient on Et +1 (equity value increases should be associated with decreases in leverage ratios). More importantly, such a study would likely judge the meaning of debt and equity value changes as explanators of leverage ratios by the R 2 of this regression. I obtained all Compustat debt and equity values for the last two years to which I had easy data access, 2002 and 2003.4 The empirical estimate of regression (8) is CLR2003 = 0.17 + 0.07 D2003
T = 15

0.04 E2003
T = 23

+ Noiset +1
R 2 = 7.7% N= 6,584

This regression even attributes a negative sign to the debt change, suggesting that rms that increased their debt had a decline in their leverage ratio. The perverse signs disappear if leverage ratio changes and net value changes are truncated at 100% and +100% (which primarily eliminates the strong eects of rms with a very small capital base).5 CLR2003 = 0.01 + 0.44 D2003
T = 45

0.16 E2003
T = 20

+ Noiset +1
R 2 = 24.6% N= 6,584

Thus, even a researcher who was fortunate enough to have truncated this way would still conclude that the explanatory power of the regression remains low. Intuitively, 75% of the
Brown University has not yet subscribed to Compustat, so I could not update the regression. However, this is a nuisance and not important for the substance of the illustration. 5 Unreported, many of the mutual correlations are very sensitive to the truncation employed. For example, there is strong mean reversion without the truncation, but the correlation between lagged capital structure and changes falls dramatically if capital ratio dierences are truncated at 100% and +100%. If the regression reported in the text is repeated with an alternative truncation rule of 300% and +300%, the regression R 2 falls to 8%.
4

12

change in leverage ratios remains unexplainedeven though this is a regression whose variables embody perfect and complete foresight. In sum, both regressions illustrate that a low R 2 in a linear regression predicting leverage changes need not be due to poor independent variables. Instead, it can be due to the linear prediction of a non-linear dependent variable.6

Rebalancing?

It was pointed out by Welch (2004, p.112) that changes in debt or equity value, and changes in debt ratio are very dierent, though only in passing. This can matter in tests of rebalancing especially in the cross-section. Some studies have explored issuing activity (one part of value changes) as the dependent variable, and a measure of deviation from a target debt ratio as the independent variable. These studies are particularly vulnerable to non-linearity concerns. Chen and Zhao (2006) point out the simple yet convincing fact that a rm that is 90-10 debt-equity nanced and which issues four times as much debt as equity (80-20) is still rebalancing towards equity, not towards debt! It follows that it is not enough to show that certain rms, which should have more equity, tend to issue more equity than debt in order to demonstrate that they are in fact rebalancing. Chen and Zhao show empirically that seemingly natural inference on other variables (specically on a target-debt ratio) can reverse: on average, a third variable can relate positively to net debt issuing activity and/or negatively to net equity issuing, and yet relate negatively to debt ratio changes.

A Functional Alternative

The solution to this problem would be easy if capital structure theory did provide clear functional specications of how third variables inuence debt ratios, debt levels, and equity levels. It does not. Some variables are likely to inuence the ratio directly. Other variables may have primarily a linear inuence on debt and equity value changes. The book value of equity essentially increases with retained earnings and equity issuing activity, decreases with depreciation and repurchasing and dividend payout activity. Thus, these variables may be good candidates for a linear inuence specication. (If equity is measured in terms of market value, then stock returns replace retained earnings minus depreciation.) Similarly,
6 Of course, in ordinary capital structure studies, the researcher usually does not have access to variables as powerful as the advance-knowledge D and E . Instead, the research usually species some lagged rm variables (attributes), which in turn may inuence either equity value changes, or debt value changes, or both.

13

collateral or interest and principal payments may have a linear inuence on the book value of debt. The same applies in turn to variables that have a linear inuence on these components. The non-linearity issue is harder for a researcher to properly address than the debt-to-asset ratio denition explained in Section I. The dependent variable must remain a leverage ratio, because it is the variable of interest in this literature. However, there is an alternative diagnostic and modeling option. When the empirical relations can work linearly through debt and equity value changes, a multiple equation system can explore whether hypothesized variables predict empirically either debt or equity year-to-year value changes, or whether they predict the leverage ratio directly. D D+E D = t0 + t1 D +E D + t2 x1 + t2 x2 + + noise

= d0 + d1 x1 + d2 x2 + + noise

= e0 + e1 x1 + e2 x2 + + noise E Such a specication can indicate which x variables are better modeled as linear components of debt and equity, and which variables are better modeled as direct linear calibrators of the non-linear leverage ratio. The correlation of the top equations hatted (predicted) capital ratio and the observed capital ratio could also be used as a measure of forecasting success for the lower two equations. (This is similar to the procedure in Welch (2004)).)

III

Issues with Appearance and Disappearance of Firms (Survivorship)

There is a general consensus that simple trade-o readjustment theories cannot explain capital structure behavior over annual horizons. The research has thus begun to shift towards measuring how strong and timely capital structure readjustment is. Inevitably, the focus then is shifting to explaining capital structure changes over longer horizons. Among papers that attempt this are Welch (2004) and Kayhan and Titman (2006) over 5-year horizons, and Lemmon, Roberts, and Zender (2006) since rm inception.

14

Average Selection Bias

Figure 3: Firms First Appearing in 1980 on Compustat/CRSP Merged Tape

50

331 IPERMs starting in 1980

15% still alive in 2003
2000

Average Existence: 10 years, truncated

40 Number of IPERMS

30

20

10

1980

1985

1990

1995

Last Compustat Year

Most research, including my own, has assumed that the population of rms remains fairly constant, i.e. that selection (survivorship bias) of rms is not an issue of rst-order importance. Figures 3 and 4 describe the persistence of PERMNOs on Compustat/CRSP, which proves otherwise. CRSP changes PERMNOs at mergers or deaths, which is the right experiment in this context: acquisitions, delisting, and bankruptcy result in fundamental capital structure change, which would then not be picked up by simple regressions that rely on consecutive rm observations that are on the tapes for multiple years. If anything, for the study of capital structure, this experiment may still be too conservative. Compustat excludes many volatile rms that drop in and out of their annual selection criteria. Figure 3 shows how many PERMNOs on Compustat that initiated in 1980 (331 rms) have died in each year, and how many remain in the nal year, 2003. The gure shows that the disappearance rate is not trivial. After 23 years, only 15% of all rms remain. The average length of existence of rms that appeared in 1980 was 10 years. Figure 4 shows the converse: how long individual PERMNOs present in 2003 have been alive. 20% of all rms have been on the tapes for fewer than 5 years. Only half of all rms remain after ten 15

Figure 4: Firms Present on Compustat/CRSP Merged Tape in 2003

100 200 300 400 500 600 700 1.0

Average Age: 10 years

Number of IPERMS

1950

1960

1970

1980

1990

2000

First Compustat Year

years. In sum, this data suggests that survivorship bias is a rst-order concern for studies that explore capital structure over longer horizons.7

Selection By Characteristic

The problem is even more dicult if birth and survival is itself related to the variables being studied, such as the dependent variable (some form of debt ratio) or some independent variables (such as rm size). Table 3 shows how dierent characteristics inuence the probability that a particular rm-year is the last or rst year for this rm on the merged Compustat-CRSP tapes. Firms which appear on Compustat seem disproportionally more fragile at the outset, and probably tend to die sooner. The birth and death rates are dierentially high enough even on an annual basis to raise concern whether selection issues can distort inference in capital structure work. Unfortunately, the issue of survivorship bias and sample selection is easier to diagnose than it is to correct. Depending on the specic study and inference sought, the solution must lie in modeling what rms are likely
This evidence may explain why the average rm alive today has a reasonably high debt ratio, even though the stock market has increased dramatically over the last 50 years. That is, it may not require a specic trade-o theory to explain this pattern.
7

16

0.0

0.2

0.4

0.6

0.8

7,732 IPERMs of 2003

Cumulative Pct of Firms Earlier Than Year X

Table 3: Annual Probability of Appearance and Disappearance on Compustat/CRSP

Probability of Birth:
Firm sorted into quintiles by

Equity Size, MV Liabilities, BV Assets (BV) Liabilities-to-Equity (BK) Liabilities-to-Equity (MK)

Low 14.5 11.3 12.6 13.5 11.7

2 9.2 10.1 9.9 8.7 9.4

3 8.3 9.6 9.0 8.0 9.6

4 7.2 8.7 8.3 8.2 8.7

High 6.4 6.9 6.4 8.4 7.7

Probability of Death:
Firm sorted into quintiles by

Equity Size, MV Liabilities, BV Assets (BV) Liabilities-to-Equity (BV) Liabilities-to-Equity (MV)

Low 10.1% 16.9% 15.6% 8.4% 6.0%

2 11.1% 11.3% 11.9% 7.2% 5.4%

3 10.1% 7.6% 8.9% 7.5% 7.3%

4 7.4% 6.1% 5.8% 9.5% 10.1%

High 8.7% 4.8% 4.3% 14.8% 18.2%

Explanation: Each cell reports frequencies for between 42,420 and 42,480 rm-years. To be included, the rm-year had to have a value for assets, and an PERMNO on merged CRSP/Compustat tape. (Note that CRSP assigns new PERMNOs after big mergers.) About 9.5% of all rm-year observations on Compustat are rst year observations, and about 9.5% are last-year observations. The upper tabular is based on rst-year rm-years, the lower on last-year rm-years. The Liability ratios are based on E/D sorts, and reported in reverse order. (A D/E based variable or sort is non-sensible, because book equity values can be negative.) Interpretation: Birth and death rate relate systematically both to dependent and independent variables in the capital structure literature.

to have appeared and disappeared. This can be done, e.g., by using a worst-case scenario to establish bounds, or by using a rst-stage model (e.g., a Heckman procedure) to adjust coecients.

IV

Theory Background of Empirical Capital Structure Tests

The remainder of the paper claries some issues in the theory that serves as background to this literature. It is useful to distinguish between mechanisms and causes of capital structure change, although they are really issues on a spectrum: At a relatively shallow level of causality (which can be called mechanisms), one can be interested in how rms have gotten to where they are. This is a question of whether

17

todays capital structure has come about via debt issues, via debt repurchases, via equity issues, via stock returns, via shares issued during M&A transactions, etc. At a deeper level of causality, one can be interested in why rms have gotten to where they are. This is a question of whether rms did so because they wanted to save on taxes, avoid issuing equity, retain nancial exibility, time the market, etc. The how question is informative about the why question, but not fully so. For example, acquirers may issue debt and/or equity, but knowing which payment method they chose does not tell us why they used one form of payment over one another, much less why they acquire another rm. On the other hand, a theory that states that rms do not issue equity because they are afraid of the negative inference of the market (either about current projects or future use of cash) could have specic implications about the how. The shallower level is easier to research than the deep level. Nevertheless, remarkably little is known here, too. Fama and French (2005) describe equity changes in Fortune-100 rms, and nd that an astonishingly large fraction (3.68% out of 3.77%) appears in the context of M&A activity. Another 1.05% fraction appears in the context of employee compensation, obtained primarily through repurchases. Simple equity issuing activity without an M&A background represents only 0.09% out of this 3.77%. However, FF have little to say either about debt dynamics or about how equity changes in smaller rms. Welch (2004) oers a non-linear variance decomposition of mechanisms that shows that capital structure is greatly inuenced by long-term debt net issuing activity and stock returns. However, Welch oers no distinction between the context in which these equity appears, or between issuing and repurchasing activity. Both papers nd that rms experience active and dynamic capital structure changes year-to-year. Most of the focus of the literature has been on exploring deeper causes, and two in particular:8 the trade-o theory (TO) and the pecking order theory (PO). The main point of this section is to outline that these two theories are not mutually exclusive, but merely that they highlight two dierent empirical predictions of the same overall theoretical framework. Again, there is no claim that this part of the paper oers anything new. The insights can be found in the set of earlier papers. They are interesting only because there are also a good number of papers, in which the distinctions that I believe to be important are either blurred or outright misinterpreted.
One paper cannot adequately describe the nuances of capital structure theoriesthere is a plethora of models that oer rich sets of implications (e.g., Harris and Raviv (1991)). Many of these papers are interested only in a particular aspect of capital structure, or in some information-theoretic phenomenon instead. These information theories are not the focus of my paper here.
8

18

The Trade-O Theory

The trade-o theory is prominently associated with work by Merton Miller, Sheridan Titman, Ronald Masulis, and others. It merely posits that rms desire to trade o the costs and benets of debt and equity (plus debt and equity adjustments), but leaves the identication of the factors for later. The most common versions of the trade-o theory identify the benet of debt as tax savings, and the cost as nancial distress. A number of papers have attempted to calibrate such friction-free static models, perhaps none so more prominently than Graham (2000). Other papers (e.g., Almeida and Philippon (2006)) have critiqued his specic estimates as too nave, either because of assumptions in Grahams estimates of the tax benets or in the estimates of nancial distress costs. One important extension of the static model is the degree to which frictions prevent rms that want to follow the trade-o theory from doing so. A number of papers (e.g., Strebulaev (2003)) have shown that the objective function can be so at that deviations from the optimum barely matter, especially in the presence of transaction costs. Even modest capital structure adjustment costs can then induce rms not to readjust. Frequently, these papers then declare victory for the trade-o theorythat the trade-o theory can explain the empirical evidence. Yet this is a phyrric victory. An alternative and equally valid interpretation of a at objective function with adjustment costs is that the trade-o theory is not useful. If the costs of adjusting are so high and the benets of adjusting so low that anything may go, then the trade-o theory is practically irrelevant. In some sense, a at objective function could even be seen as the NULL against which a tradeo theory is tested. An even more general version of the trade-o theory allows the target to be dynamic or at least dierent across rms. For example, the trade-o adjustment models in Fischer, Heinkel, and Zechner (1989), Leland (1998), Leland and Toft (1996), and Hennessy and Whited (2004) are sophisticated attempts to derive an optimal dynamic capital structure. These models advantages is that if their assumptions are met, the models oer accurate quantitative predictions, the likes of which are not easily obtainable in the context of simpler and stylized models. However, the models are no panacea. Their detailed approaches do not easily allow an empiricist to embed specic alternatives, require certain strong assumptions (e.g., what kind of debt can be issued and when), and make it dicult for the casual reader to judge where the degrees of freedom (which the models t) lie. Moreover, they are dicult to solve and understand, and it is usually left to the reader to judge their robustness and specicityor even how at the objective functions are, both in a static 19

and in a dynamic sense. Generally, very few structural models have enjoyed wide success and use, either in corporate nance or asset pricing. In the absence of a generally agreed successful standard, it is simply not clear what the right model to use is. In any case, there is consensus in the profession that a simple friction-free trade-o model cannot explain the evidence. Firms do not readjust their capital structures on short horizonssay 1 to 2 years. There are also few who would doubt that rms try to readjust at least partially over longer horizons, say 5 to 10 years. Estimating the extent and speed of readjustment is now becoming one focus of this literature. However, Leary and Roberts (2004) point out that rms may adjust capital structure in lumps, rather than continuously, which presents interesting theoretical and empirical complications.

The Pecking Order (Adverse Selection, Slack, and the Financing Pyramid)

The pecking order theory rst arose in Donaldson (1961), but has since been most prominently associated with Stewart Myers (Myers (1984), Myers and Majluf (1984)). It was at rst narrowly interpreted to mean that rms never issue risky instruments, because investors infer negative information about existing projects when a rm wants to issue a risky instrumenta pure adverse selection argument. In later and broader interpretations, it was interpreted to be, as it names suggest, a funding preference theory, in which rms fund new projects rst internally with retained earnings, then with debt, and only nally with equity. In such a world, nancial slack becomes valuable because it can provide internal funding for future projects when external equity is too expensive. Over time, the pecking-order theory has also acquired an identication with a number of related phenomena. Consequently, it is useful to clarify the phenomena being discussed. The pecking order: The preference to fund new projects with more senior claims. Adverse selection: The fact that insiders know more than potential new investors. Financial slack: An internal cash reserve that rms can tap. The nancing pyramid: A capital structure that contains more senior than junior claims. A pecking order can arise in any trade-o theory in which issuing junior claims is more expensive than issuing senior claims. It can be introduced not only through adverse selection costs to equity (the traditional method), but also through agency costs to equity (e.g., Morellec (2004)), or even through higher physical distribution costs of new equity

20

shares.9 For example, investors may fear that equity issues might give managers more access to unrestricted capital, which reduces the rm value. Fearing such negative reactions enough (i.e., if they outweigh the benets to issuing equity), managers then avoid issuing equity, even in the absence of adverse selection in the sense of negative inference about existing projects. The complement, benets of debt, can also generate pecking orders (for example in Auerbach (1979)). In general, it is not dicult to create models in which internal equity is cheap (e.g., Lewellen and Lewellen (2004)). Any such theory can then also justify a negative announcement eect, because the attempt to issue informs investors of managerial intent and/or that the rm had to resort to such costly methods of equity nancing. Figure 5 illustrates the relationships between these phenomena. The most important aspect of the gure is that it considers them to be distinct. Each can occur without the other, although the presence of a phenomena higher up in the gure can help cause phenomena higher down. For example, adverse selection can cause a pecking-orderbut so can other costs of equity. Financial slack is a natural corporate response when there are future costs of obtaining new capital. And a nancing pyramid can result from a pecking order over time, but it can also be inuenced by other factors, such as corporate value changes. The gure also claries that one cannot conclude from the presence of a pecking order that adverse selection is at work, and that one cannot conclude from the presence of a nancing pyramid that a pecking order is at work. It is only true that in the absence of other forces, adverse selection causes a pecking order. On a historical note, when Stewart Myers proposed the pecking-order theory, among his intentions was to provide a NULL hypothesis against which the trade-o theory could be tested. One problem of such a perspective, however, is that the trade-o theory is really only a statement of optimizationsuch as value maximization or managerial utility maximization. There is no clear upfront identication of the trade-o forces. Therefore, if it were to be viewed as the alternative, the pecking-order would have to be a rejection of generic optimization, which was surely not Myers intent. This has been confounded by the fact that the two theories have indeed often been mistakenly presented as being
This has also recently been derived in Frank and Goyal (2005). Like Bolton and Dewatripont (2005, p.119f), they also point out that it is possible to have a dierent form of adverse selection create an inverse pecking ordera preference for equity.
9

21

Figure 5: Related But Distinct Phenomena

Traditional Grouping (PO) Adverse Selection

Managers know more about projects

Other Conceivable Causes Moral Hazard, Transaction Costs

Issuing is costly Markets react badly. Potential Causes:

@ @ @ R @ R @ R @

Pecking Order
Dynamic PO

Agency Issues
Managers dislike high debt levels or forget to pay out earnings.

Potential methods:

Broader Activity
Earnings retention.

Managers dislike issuing, esp. equity

@ @ R @ R @

Potential Causes:

Financial Slack
Firms are underlevered to avoid future equity issues

Agency Issues
Managers dislike high debt levels or forget to pay out earnings.

Potential methods:

Broader Activity
Debt/Payout Policy.

@ R @
Potential Causes:

Slow Active Readjustment

Firms remain underlevered

Value Changes
Stock/Bond Returns (MV). Ret. Earnings, Deprec. (BV)

@ R @

Potential methods:

Financing Pyramid
Firms are more debt nanced

Broader Activity
Debt/Payout Policy.

Broader activity includes repurchasing activity, payout policy, debt activities, etc. Multiple arrows indicate a closer and more general connection, while single arrows mean a possible relation in some, though not all companies.

mutually exclusiveon two opposing ends of one spectrum.10 , 11 This is not at all the case. Instead, one can view the pecking-order theory as the funding phenomenon that is the result of a set of forces that postulate high costs to issuing more junior securities and which are balanced by the rm against their benets. If the marginal cost of more equity is high enough, then rms tend to fund projects with more senior securitiesa pecking
10 It is sometimes suggested that the dierence between pecking-order and tax benets of debt is that the former is about issuing changes in debt and equity, while the latter is merely about the level of debt and equity. Yet, it would seem natural even in a pecking-order to think of an equity repurchase as good information, the same way one would think of equity issue as negative information. In this interpretation, the dierence between the PO and the TO is [a] about the fact that the pecking-order does not as explicitly entertain a benet to equity; and [b] that the pecking-order is about an asymmetric reaction to good and bad inference. 11 Some papers show that simulated runs of either the trade-o theory or of a pecking order can explain the empirical evidence. This is correct, but it does not mean a rejection of the other theory.

22

order which is the outcome of a plain capital structure cost-vs-benet trade-o. Coercing the two theories to be viewed as mutually exclusive, one being the converse of the other, is confusing. This does not mean that PO tests are necessarily TO tests. The PO tests are about specic empirical predictions, even though they are based on the same theoretical structure. They are about how rms fund new projects with additional capital, while tests of the tradeo theory can be about the relative benets of debt and equity in a more general context, including situations in which there is no need to fund new projects.

A Short Clinical Analyses

Much empirical capital-structure work has been conducted through the lenses of these theories. This has conrmed that both trade-o and pecking order behavior are present, at least in some rms. However, it is not clear whether these empirical tests have captured the rst-order determinants of capital structure, or merely marginal eects.12 In fact, with the exception of one working paper (Frank and Goyal (2003)), the literature has not even answered such basic questions as to whether large rms or small rms tend to have higher debt ratios. Even without a good theory, it would be interesting to learn more about whether and how such basic characteristics as rm size or industry (MacKay and Philips (2004)) are capital structure determinantsand then to build a theory why this is so. Thus, it could be useful to describe the rst-order dierences across rms that have high or low debt ratios, that are then to be explained by theories. In this vein, Tables 4 and 5 present a short clinical analysis of current capital structure. They show the rms that have the lowest and highest debt ratios among S&P 500 members in February 2006, as obtained from Yahoo!Finance. It does not require a rigorous analysis to notice a number of strong regularities (most of which have appeared in the literature): 1. Industry seems to play an important role. Among the most highly levered companies, there are a large number of nancial services and automobile related companies. These can be fundamentally dierent from industrial rms. For instance, FNMA has 36 times as much debt as equity.
12 Looking at these theories at such a broad canvas suggests a higher hurdle. With a large set of possible proxies, tens of thousands of rm-years, and fairly general specications, the goal should not be merely to obtain marginal statistical signicance. Instead, the theoretical proxies should explain a reasonably large fraction of capital structure variation. Losely speaking, it is not just the t -statistic, but the R-square that we need to identify rst-order important phenomena.

23

Table 4: Capital Structure: Highly Levered S&P500 Companies in February 2006

Industry D/E-MV L/A-MV L/A-BV MV-E #N/A 81% #N/A 83% 57% 93% 98% 91% 73% 95% 91% $10.4 $14.2 $69.4 $40.3 $22.7 $44.8 $3.1 $11.9 $67.5 $10.8 $50.8 BV-E Totliab LTD CDT Tax RD Int OCF ICF FCF N Rating R R5 30% 37% 5% 10% 19% 29% 4% 48% 48% R10 282% 160% 2027% 8% 555% 18% 34% 76% 22% 87% 51% 10% 96% 1845% 16% 71% 45% 61% 24% 25% 224% 13% -

Ticker

Name

24
62% 58% $63.4 $3.9 96% 50% 36% 81% 63% 42% 20% $24.0 $38.6 $2.9 $3.2 $15.9 $11.2 $29.4

84% 15% 78%

$10.8 $19.7 $2.0

15% 6% 203% 35% 9%

89%

FNM TXU SLM FRE GT LU MS GM BSC LEH UST AES F GS CFC CNP CIT AMZN NAC EP ET AXP CZN PBI THC AZO GE CAT DJ CMS DE HNZ CL

Fannie Mae TXU SLM Freddie Mac Goodyear Lucent Morgan Stanley General Motors Bear Sterns Lehman Bros UST AES Corp. Ford Goldman Sachs Country Finl Centerpoint CIT Group Amazon Navistar El Paso E*Trade American Express Citizens Comm. Pitney Tenet Autozone General Electric Caterpillar Dow Jones CMS Energy Deere HJ Heinz Colgate-Palmolive

F U F F C IT F C F F C U C F F U F IT C I F F IT C H S * I S U I C C

3597% 2820% 2425% 2240% 7429% 1836% 1792% 1708% 1430% 1296% 1280% 1263% 1191% 1170% 860% 700% 687% 616% 565% 520% 510% 440% 406% 360% 350% 340% 339% 305% 291% 299% 272% 272% 255%

#N/A 98% 96% #N/A 100% 98% 97% 97% 96% 96% 95% 94% 95% 96% 93% 92% 89% 93% 94% 89% #N/A 91% 84% 88% 90% 91% 84% 82% 91% 85% 80% 75% 84%

#N/A $0.5 $3.8 #N/A $0.1 $0.4 $29.2 $14.6 $10.8 $16.8 $0.1 $1.6 $13.0 $28.0 $12.8 $1.3 $7.0 $0.2 $0.5 $3.4 #N/A $10.5 $1.0 $1.3 $1.0 $0.4 $109.4 $8.4 $0.2 $2.3 $6.9 $2.6 $1.4

#N/A $25.1 $95.5 #N/A $15.6 $16.0 $869.3 $461.5 $281.8 $393.3 $1.3 $28.0 $256.5 $678.8 $162.3 $15.8 $56.4 $3.5 $7.1 $28.4 #N/A $103.4 $5.4 $9.3 $8.8 $3.9 $564.0 $38.6 $1.6 $13.4 $26.8 $8.0 $7.2

#N/A $11.4 $88.1 #N/A $4.7 $5.1 $298.0 $285.8 $66.0 $214.1 $0.8 $16.8 $154.3 $123.3 $76.2 $8.6 $47.9 $1.5 $2.0 $17.0 #N/A $30.8 $4.0 $3.8 $4.8 $1.9 $212.3 $15.7 $0.2 $7.3 $11.7 $4.1 $2.9

#N/A $2.3 $3.8 #N/A $0.4 $0.4 $415.4 $121.2 $119.1 #N/A $1.8 $353.3 $36.4 $0.7 $0.8 $1.2 #N/A $15.6 $0.2 $0.9 $0.0 $158.2 $10.1 $0.2 $0.4 $6.9 $0.6 $0.5

#N/A #N/A #N/A #N/A #N/A #N/A 5 $0.6 - $0.8 $2.5 $1.0 $1.6 7 $0.7 - $3.1 $0.7 $15.7 $15.5 11 #N/A #N/A #N/A #N/A #N/A #N/A 5 $0.3 - $0.4 $0.9 $0.4 $0.2 80 $0.2 $1.2 $0.3 $0.7 $1.3 $0.4 30 $1.9 - $24.4 $31.4 $4.1 $32.1 53 $5.9 - $15.8 $16.9 $8.6 $3.5 327 $0.7 - $4.1 $14.0 $0.2 $15.9 11 $1.6 $0.2 $17.8 $7.5 $0.4 $7.4 22 $0.3 - $0.1 $0.6 $0.0 $0.8 5 $0.5 - $1.9 $2.2 $0.8 $1.2 30 $0.5 - $7.6 $21.7 $7.4 $20.7 300 $2.6 $0.4 $18.2 $12.4 $1.1 $19.4 31 $1.6 - $5.6 $11.7 $41.8 $53.7 54 $0.2 - $0.7 $0.0 $0.0 $0.0 9 $0.5 - $1.9 $2.9 $5.0 $3.2 6 $0.1 - $0.1 $0.7 $0.8 $0.2 12 $0.1 $0.2 $0.1 $0.2 $0.1 $0.1 14 $0.3 - $1.4 $0.3 $0.5 $0.2 5 #N/A #N/A #N/A #N/A #N/A #N/A 3 $1.0 $0.0 $0.9 $8.0 $17.3 $6.4 65 $0.1 - $0.3 $0.8 $0.2 $0.5 6 $0.3 $0.2 $0.2 $0.5 $0.5 $0.1 34 $0.1 - $0.4 $0.8 $0.4 $0.3 53 $0.3 - $0.1 $0.6 $0.3 $0.4 29 $3.9 - $15.2 $37.6 $35.0 $6.1 316 $1.1 $1.1 $1.0 $3.1 $3.5 $1.2 85 $0.0 - $0.0 $0.2 $0.5 $0.3 7 $0.2 - $0.5 $0.6 $0.5 $0.1 8 $0.7 $0.7 $0.8 $1.2 $5.2 $3.1 47 $0.3 - $0.2 $1.2 $0.3 $1.1 41 $0.7 - $0.1 $1.8 $0.2 $1.5 35

NLS BBBA AAB+ B A+ B A A+ A B+ BBA+ A BBB A BBBBB+ B+ A+ BB+ A+ B BBB+ AAA A BBB+ BB AAAA-

5% 4%

12% 22%

624% 41%

1% 21% 15% 39% 7% 11% 10%

18% 176% 30% 48% 64% 15% 8%

84% 445% 66% 8% 332% 137% 361%

Source: Yahoo. F= Financial Services. C= Consumer Goods (incl Auto). U= Utilities. H= Healthcare. I=Industrial. IT= Infotech. BT= Biotech. Please note that D/E and L/A here were provided the rank order, as of February 2006. However, this cannot be easily relled now. D/E is the market-based debt-equity ratio. L/A is the liability-asset ratio, market-value based. Totliab= total liabilities, LTD = long-term debt, CDT = debt in current liabilities. Tax are Income taxes, RD is R&D expense, Int is interest expense. OCF is operating cash ow, ICF is investment cash ow, FCF is nancing cash ow. Dollar gures are in billions. N is number of employees, in thousands. Rating is from S&P. R, R5, and R10 are one, ve, and 10 year rates of returnto be recomputed.

Table 5: Capital Structure: Zero-Levered S&P500 Companies in February 2006

Industry D/E-MV L/A-MV L/A-BV MV-E BV-E Totliab LTD CDT Tax RD Int OCF ICF FCF N Rating R R5 R10

Ticker

Name

8% 1% 8% 2% 6% 3% A+ A+

1% 115% 11% 3% 123% 26%

10% 680% 55% 778% 7% 2971% 866% 646% 424% -

4% 3%

47% 44% 18% 139% BBB BBB+ BBB

947%

3% 2%

14% 22% 6% 19% BBB

748% 530%

25
5% 4% 9% 5% 2% 14% 2% 3%

AAA

25% 177% 14% 45% 21% 35% 13% 556% BBA35% 70% 28% 71%

419% 379% 384% -

MSFT GOOG CSCO QCOM AAPL EBAY WAG GILD BRCM ADBE GENZ ACE BII ERTS FRX PAYX ADI MXIM NTAP LLTC BBBY KLAC TROW APOL XLNX INTU ADSK NVDA VRSN ABI APCC CPWR QLGC TEK PMTC AMCC BB+

Microsoft Google Cisco Qualcomm Apple Ebay Walgreen Gilead Broadcom Adobe Genzyme Ace Biogen Electronics Arts Forest Labs Paychex Analog Devices Maxim Network Appliance Linear Tech Bed Bath Beyond Kl A-Tencor T Rowe Price Apollo Xilinx Intuit Autodesk Nvidia Verisign Applera (Bio) APC Compuware Qlogic Tektronix Parametric Tech. Applied Micro

IT IT IT IT IT IT C H IT IT BT F BT IT H IT IT IT IT IT C IT F S IT IT IT IT IT T IT IT IT IT IT IT

0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0%

32% $269.3 $48.1 8% $123.3 $9.4 27% $105.3 $25.8 11% $71.2 $11.1 35% $61.0 $7.5 15% $60.8 $10.0 39% $8.9 20% $3.0 16% $16.5 $3.1 24% $22.2 $1.9 25% $5.1 81% $11.8 17% $6.9 20% $3.5 12% $3.1 68% $1.4 19% $3.7 14% $11.6 $2.6 30% $1.7 12% $11.0 $2.0 31% $2.2 24% $3.0 12% $2.0 46% $10.4 $0.7 12% $8.7 $2.7 32% $9.3 $1.8 43% $9.9 $0.6 28% $1.2 36% $53.5 $2.0 26% $4.9 $2.3 21% $1.6 39% $1.5 7% $1.0 32% $23.3 $1.0 59% $17.0 $0.3 11% $1.0 $0.2 $0.8 $4.5 $0.0 $0.0 $0.0 -

$22.7 $0.9 $9.8 $1.4 $4.1 $1.7 $5.7 $0.7 $0.6 $0.6 $1.7 $50.6 $1.5 $0.9 $0.4 $3.0 $0.9 $0.4 $0.7 $0.3 $1.0 $0.9 $0.3 $0.6 $0.4 $0.9 $0.5 $0.5 $1.1 $0.8 $0.4 $1.0 $0.1 $0.5 $0.5 $0.1

$4.4 $0.7 $2.0 $0.7 $0.5 $0.5 $0.9 $0.1 $0.3 - $0.0 $0.2 $0.0 $0.2 $0.3 $0.3 $0.1 $0.1 $0.3 $0.2 $0.2 $0.3 $0.1 $0.2 $0.1 $0.3 $0.2 $0.2 $0.3 $0.1 $0.1 $0.0 $0.0 $0.0 $0.1 $0.0 $0.1 $0.0 $0.1 $0.0 $0.0 $0.0 $0.0

$6.2 $0.6 $3.2 $1.0 $0.5 $0.3 $0.3 $0.7 $0.4 $0.5 $0.7 $0.8 $0.3 $0.5 $0.3 $0.2 $0.1 $0.3 $0.3 $0.3 $0.2 $0.3 $0.1 $0.3 $0.1 $0.2 $0.1 $0.2 $0.1 $0.1

- $16.6 $0.0 $2.5 $7.1 $0.0 $2.7 $2.5 $0.0 $2.0 $1.4 $0.0 $0.7 $0.4 $0.7 $0.0 $0.7 $0.2 $4.3 $0.0 $0.9 $0.6 $0.9 $0.5 $0.0 $0.7 $0.7 $0.0 $0.5 $0.5 $0.6 $0.0 $0.5 $0.0 $0.5 $0.6 $0.3 $0.6 $0.4 $0.0 $0.1 $0.5 $0.0 $0.2 $0.2 $0.2 $0.2 $0.0 $0.1 $0.1 - $0.0

$15.0 $41.1 61 $3.4 $4.4 5 $0.5 $7.8 38 $0.8 $1.1 9 $2.6 $0.5 14 $2.5 $0.5 11 $0.4 $0.8 131 $0.7 $0.4 1 $0.2 $0.3 4 $0.3 $0.2 5 $1.2 $0.3 8 $5.6 $1.3 10 $0.4 $0.9 3 $0.1 $0.5 7 $0.1 $1.0 5 $0.2 $0.2 10 $0.0 $0.6 8 $0.5 $0.2 7 $0.4 $0.0 4 $0.1 $0.3 3 $0.4 $0.3 33 $0.2 $0.1 5 $0.1 $0.1 4 $0.2 $0.8 11 $0.0 $0.1 3 $0.2 $0.5 7 $0.2 $0.3 4 $0.2 $0.0 2 $0.1 $0.5 4 $0.1 $0.0 4 $0.1 $0.0 7 $0.2 $0.0 7 $0.0 $0.1 0 $0.1 $0.2 4 $0.2 $0.0 3 $0.2 $0.0 0

6% 15% 4% 55%

194% 29%

Source: Yahoo. F= Financial Services. C= Consumer Goods (incl Auto). U= Utilities. H= Healthcare. I=Industrial. IT= Infotech. BT= Biotech. Please note that D/E and L/A here were provided the rank order, as of February 2006. However, this cannot be easily relled now. D/E is the market-based debt-equity ratio. L/A is the liability-asset ratio, market-value based. Totliab= total liabilities, LTD = long-term debt, CDT = debt in current liabilities. Tax are Income taxes, RD is R&D expense, Int is interest expense. OCF is operating cash ow, ICF is investment cash ow, FCF is nancing cash ow. Dollar gures are in billions. N is number of employees, in thousands. Rating is from S&P. R, R5, and R10 are one, ve, and 10 year rates of returnto be recomputed.

 Some rms have slipped into this category due to poor performance, such as Goodyear, GM and Ford. Among the least levered companies, there are disproportionally many information technology companies. 2. There are a number of rms which have very low equity book values and much higher market value. For example, Amazons equity was $20 billion in market value but only $0.2 billion in book value. (Theoretically, the book value of equity can be negative.) 3. Among highly levered rms, total liabilities can be quite dierent from nancial debt. For example, Ace (an insurance rm) listed $50.6 billion in total liabilities but no nancial debt. 4. Taxes consume about a third of the operating cash ows of many zero-leverage rms. Many highly levered rms have no or do not report R&D expenses. R&D, taxes, and interest expenses can be large in terms of operating cash ows, but are often only a small fraction of rm asset value. 5. The distribution of credit ratings provides some insight about the reason why rms are highly levered. Goodyear, Lucent, GM, AES, Ford, Amazon, Navistar, Citizens, and CMS have junk bond status. This is also partly reected in their historical stock market rates of return. 6. Highly indebted rms are older and have more employees than zero-levered rms. These seem to be rst-order eects. Clinical analyses can sometimes point out the pitfalls in more formal tests of capital structure theory. For example, a number of theories (e.g., Titman (1984)) predict that rms with intangible assets that would dissipate in nancial distress should have more equity. Some tests have used R&D expenditures as a proxy. It is indeed correct that rms with high R&D expenditures and in the IT industry have low debt ratios. Yet, I would argue that the question remains whether this should be interpreted as good evidence that the intangibility of assets has induced these rms not to take on leverage. In my opinion, the table suggests that this may not be the case. Microsoft, Google, Cisco, Qualcomm, Apple, etc., are probably not unlevered because they chose such structures in order to avoid bankruptcy at all cost. Given their capitalization and product lines, a 10% debt-ratio (rather than 0%) would almost surely not increase their expected costs of bankruptcy enough to outweigh the immediate gain in lower tax obligations. This would suggest that when R&D expenses are used in terms of proxying for distress costs, they are not only noisy but also have high type-I error: The tests could suggest that the theory were 26

true when it is false (when low debt is driven by other considerations, instead). A more likely explanation is that these particular rms in R&D intensive industries have experienced high operating cash ows in the past. A full control for such third factors may not be easyand it is not clear to me what the role of R&D is. A better research design to test whether rms with high R&D expenses have low debt ratios because they need to avoid nancial distress would be to search for the impact of R&D principally among rms that have a reasonable probability of encountering nancial distress.

Future Directions in Empirical Capital Structure Research

In a working paper critiquing the past methods of this literature, it seems not entirely out of place to use two pages to speculate about future promising directions in this literatureeven if this section may ultimately not be suitable for publication. Despite years of capital structure research, it is not clear to me what the important empirical ndings are. As to rst-order eects, it is my impression that we are on solid ground with respect to the following phenomena: most rms are reluctant to nance new projects with new equity (a pecking order), except in the context of acquisitions; that (long-term) and other debt net issuing activity is common; that there are industry dierences (possibly caused by industry performance dierences); that acquisitions play an important role, and that historical stock returns are important factors, because are not immediately counteracted by rms. It is not clear to me whether the following are rst-order or second order eects: Firms seem to want to be similar to their peers. There is also some evidence in favor of the trade-o theory (especially with respect to tax eects), and some evidence in favor of a capital structure that can be explained by an agency conict (the desire of managers to avoid debt and have cash or equity to take over other companies). Other evidence seems more preliminaryfor example, we are just learning more about dynamic nancing policy and market timing. As to future research, the following appear to be promising avenues to me: 1. Back to Basics: It would be useful to learn the rst-order dierences among rms capital structure, even if not guided by specic theory tests. This may help develop future theories that explain the most important aspects of capital structure better. 2. M&A Activity: Fama and French (2005) have documented that M&A activity can be an order of magnitude more important in explaining capital structure than ordinary

27

equity issuing activity. We also know that mergers and acquisitions are responsible for large changes in debt. It will require a more unied perspective of capital structure and acquisition activity to better understand capital structure. An interesting rst paper exploring methods of payment and M&A is Baker, Coval, and Stein (2004). 3. Survey Evidence: Graham and Harvey (2001) initiated the rst modern survey of CFOs. If we want to learn why corporations end up with certain capital structures, learning how the main decision makers think is essential evidence. Alas, the weakness of this literature is that it has not linked actual behavior to survey responses. For example, many managers claim to pursue a target debt ratiobut the empirical evidence in this respect is not strong. To make progress, we must be able to correlate individual managers survey responses with their observed behavior. To make even more progress, we should confront CFOs claiming one type of behavior and behaving dierently with the evidence in order to learn whether their survey response was a mistake, their capital structure behavior was a mistake, whether times have changed, or whether we have misunderstood them altogether. 4. Behavioral Finance: Linking the survey evidence to behavior could lead to a more productive use of behavioral nance in corporate nance. After all, capital structure decisions are made by managers and with relatively modest forces capable of arbitraging away mistakes. Here, I mean not general motivation, but direct identication of particular rms CFO answers with their actual behavior, so that it can be checked, e.g., whether managers who claim they rebalance all the time actually do so. Still, even without good direct survey links, this area has produced some interesting ndings. Baker and Wurgler (2002) were generally motivated by the survey evidence and nd that managers attempt to time their equity issues, although the role of stock prices in predicting issuing activity was mentioned by Marsh (1982), Taggart (1977), Myers (1984) and others. They argue that timing eects are persistent enough to create strong path dependence, and explain a good part of the contemporaneous capital structure variation in rms. However, their ndings are not undisputed, either. For example, Welch (2004),13 Roberts and Leary (2005) and Kayhan and Titman (2006)
13 Some papers (e.g., Roberts and Leary (2005)) group Welch (2004) with Baker and Wurgler (2002). However, the two papers could not be more dierent. The former is about a passive change of capital structure due to stock returns, regardless of active managerial change. The latter is about active managerial behavior in the face of dierent stock returns, regardless of mechanical, passively induced changes. The two eects are also easy to disentangle.

28

wonder how strong the eect iscompanies can issue both debt and equity, and pay out and repurchase, in response to value increases. The jury is still out. Another promising behavioral research strand has arisen in Bertrand and Schoar (2003). They ask to what extent CFO behavior is driven by non-nancial factors, such as education, relationships, etc. Similarly, in a series of paper, Malmendier (e.g., Malmendier and Tate (2005)) has begun to measure managerial overcondence and its impact on corporate behavior. 4. Natural Experiments In the last decade, the econometric tool-set and the method of thinking about econometric issues has improved considerably. Instrumental variable and regression discontinuity techniques have helped to recast and analyze a number of phenomena as natural experiments. There have been some attempts in corporate nance, e.g., Opler and Titman (1994), Zingales (1998), Chevalier and Scharfstein (1995), Lamont (1997), and others. In the capital structure arena, phenomena waiting to be better exploited are tax law changes which only aect some companies, the sudden and unforeseen destruction of assets of some companies, discontinuity in credit ratings (Kisgen (2006)), and so on. 5. Event Studies In the late 1980s, there were a large number of event studies. The technique was perhaps over-used. But the pendulum has swung back too far, and they have so fallen out of favor that they are now under-used.14 Event studies are a form of a natural experiment. The exogenous variable is clear (the corporate behavior) as is the endogenous variable, the nancial market response at the announcement. A good event study can help illuminate whether value eects of capital structure changes are positive or negative, especially when combined with other evidence. Many good event studies were published in the 1980s and thus were based on data from the 1960s and 1970s. It is often not known whether or how the nancial markets have changed in the assessment of value changes associated with capital structure events.

Admittedly, a second reason for their fall in popularity has come with the advent of behavioral nance. We are more agnostic today as to whether limits of arbitrage prevent the nancial markets from fully incorporating information upon announcement. We understand that nancial markets are more noisy creatures than we once thought. Nevertheless, event studies are powerful tools.

14

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VI

Conclusion

The papers main contribution was to critique three issues, and oer suggestions for future specications. 1. Proxy Choice: The opposite of nancial debt is not equity, but in large part non-nancial liabilities. Researchers should not use a nancial-debt-to-asset ratio. Instead, they should use either a nancial-debt-to-nancial-equity ratio or a liability-to-asset ratio. 2. Specication: Linear regressions predicting capital structure ratios can have low explanatory power, when they are confronted with non-linearities in the dependent variable. Debt-capital ratios are inherently non-linear in debt and capital. The example in this paper showed that even with perfect foreknowledge of equity and debt changes, a linear regression may pick up less than 10% (25% if variables are truncated) of the variation in leverage ratios. Interpreting t as a measure of how well variables explain capital structure can then be misleading. Researchers could estimate a system that allows for both linear and non-linear eects of any third variables. 3. Survivorship: Corporate birth and death rates suggest signicant selectivity biases, even on annual horizons. About one in ten rms disappears and/or appears in any given year. Moreover, there are systematic dierences (in capital structure and other characteristics) as to what types of rms appear and disappear. This bias renders multi-year long-run explorations progressively more dicult. Researchers can use Heckman techniques to model the birth and death processes of the observations that ow into their capital structure estimation. Finally, the paper has taken some unusual liberties clarifying and opining on theoretical interpretations and future work. First, it has argued that it is useful to draw a distinction between capital structure mechanisms and causes. Remarkably little is known about mechanisms. Second, when it comes to causes, the empirical literature has often suggested that the takeover and a pecking order theory are opposites or mutually exclusive. However, they are merely dierent implications of the same theory. Third, the paper suggested that it would be useful to distinguish better between the pecking order, adverse selection, nancial slack, and the nancing pyramid as discrete empirical phenomena. Fourth, the paper ponticated as to some promising avenues for further research.

30

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