How Important Is Capital Structure Policy to Firm Survival?

Y.PeterChung

A.GaryAndersonGraduateSchoolofManagement UniversityofCalifornia,Riverside peter.chung@ucr.edu

HyunSeungNa
CollegeofBusiness CityUniversityofHongKong hyunsna@cityu.edu.hk

RichardSmith*
A.GaryAndersonGraduateSchoolofManagement UniversityofCalifornia,Riverside richard.smith@ucr.edu

Currentdraft:February20,2013 Abstract If there is an economically important optimal capital structure, then firms that deviate too far from the optimum will face greater risk of failure or acquisition. Using data from the oil industry we find no significant evidence that capital structure policy affects acquisition or failure probability. Firms appear to increase leverage when they face attractive growth opportunities or when poor operating performance reduces equity value or compels borrowing. Firms are acquired when rapid growth has reducedfinancialslack.Inaclinicalexamination,weaddressthequestionofhowfirmswithpersistently low leverage can operate and survive for many years without being targeted for acquisition. Our evidence supports the peckingorder hypothesis including acquisition among potential financing sources.
Keywords:Capitalstructure,Bankruptcy,Acquisition,Oilexplorationanddevelopment JELCodes:G32,G33,G34,L25,L71 *Correspondingauthor. We thank Warren Bailey, Harry DeAngelo, JunKoo Kang, and David Mayers, for comments on prior drafts. Chung and Smith appreciate the financial support from the A. Gary Anderson Graduate School of Management for this research.

Electronic copy available at: http://ssrn.com/abstract=1952199

How Important Is Capital Structure Policy to Firm Survival?

Currentdraft:February20,2013

Abstract
If there is an economically important optimal capital structure, then firms that deviate too far from the optimum will face greater risk of failure or acquisition. Using data from the oil industry we find no significant evidence that capital structure policy affects acquisition or failure probability. Firms appear to increase leverage when they face attractive growth opportunities or when poor operating performance reduces equity value or compels borrowing. Firms are acquired when rapid growth has reducedfinancialslack.Inaclinicalexamination,weaddressthequestionofhowfirmswithpersistently low leverage can operate and survive for many years without being targeted for acquisition. Our evidence supports the peckingorder hypothesis including acquisition among potential financing sources.
Keywords:Capitalstructure,Bankruptcy,Acquisition,Oilexplorationanddevelopment JELCodes:G32,G33,G34,L25,L71

Electronic copy available at: http://ssrn.com/abstract=1952199

How Important Is Capital Structure Policy to Firm Survival?

1. Introduction Thetwopredominanttheoriesofcorporatecapitalstructurearetheoptimaltradeoffhypothesis

andthepeckingorderhypothesis.Underthetradeoffhypothesis,taxes,distresscosts,andagencycosts combinetoyieldanoptimalcapitalstructureandfirmsarepunishedfordeviatingfromthatoptimum throughlowerriskadjustedreturns,andpotentiallyfailureoracquisition.Underthepeckingorder hypothesis,capitalstructureisaresultofinvestmentopportunitiesandcapitalretentionpoliciesinthe presenceofasymmetricinformation.Firmsconfrontedwithnewinvestmentopportunitiesseekto mitigateadverseselectioncostsbyexploitingtheleastriskyformsoffinancingfirst.Leverageincreases wheninvestmentopportunitiesareabundantanddemandforinvestmentcapitalishigh.Leverage decreaseswhenfreecashflowishighandinvestmentopportunitiesarescarce.Underthishypothesisfirms arepunishedthroughthefailuretomaintainenoughfinancialslacktotakeoninvestmentswithout incurringsubstantialadverseselectioncostsorbyretainingmoreslackthanisoptimal. Thestaticversionofthetradeoffhypothesis(KrausandLitzenberger(1973),JensenandMeckling (1976),andMorellec(2004),amongothers)andthepureversionofthepeckingorderhypothesis (Donaldson(1961)andMyersandMajluf(1984))arethesimplestarticulationsofthecompetingtheories. Bridgingthesetwoareseveralhybrids.Fischer,Heinkel,andZechner(1989)andothersbeginwiththe tradeoffhypothesesandproposethatempiricalcapitalstructureisdynamic.Theyrecognizethat restructuringissubjecttoeconomiesofscalesothatfirmscandriftawayfromtheirtargets.Theyreturnto thetargets,orevenovershoot,usinglumpyepisodesofdebtfinancing.Fromtheotherdirection,Myers (1984)introducesamodifiedpeckingorder,whichprovidesthatthefirmsfacedebtcapacitylimitations andfrictionsassociatedwithraisingcapital,andcannotstrictlyadheretothepeckingorderpredictions. Synthesizingthesetwo,DeAngeloandDeAngelo(2007)hypothesize,consistentwiththetradeoff hypothesis,thatfirmsdohavetargetcapitalstructures,butthat,consistentwiththepeckingorder hypothesis,theymaydepartfromthetargetsbyissuingdebttopursueattractiveinvestmentopportunities.

Moreover,thetwomainhypothesesarenotmutuallyexclusive.Empiricalcapitalstructurecouldbe affectedbyconsiderationsofbothoptimaltradeoffandadverseselection. Inthispaper,weaddressthequestionofwhethercapitalstructuremattersbyexaminingwhat happenstofirmsthatoperatewithcapitalstructuresthataremuchdifferentfromindustrynormsandthat deviatemateriallyfromendogenousestimatesofcapitalstructurepolicy.Ourempiricalapproachismost directlyatestoftheoptimaltradeoffhypothesis.Ifthereisaneconomicallyimportantoptimalcapital structure,firmswithcapitalstructuresmuchdifferentfromindustrynormsandfromendogenousestimates ofcapitalstructurepolicyaremostlikelytobeoperatingawayfromwhatisoptimalandwillbeat competitivedisadvantage.Suchfirmsarelesslikelytobeabletosustainprofitableoperationsandare morelikelytobeattractiveasacquisitiontargetsbythosewhowouldseektocorrectthecapitalstructure. Thosethatoperateclosetotheiroptimumsshouldbeabletogeneratemorenetcashflowandbebetter abletotakeonnewinvestmentopportunities,includingbyacquisitionoffirmsthatoperateawayfrom theiroptimumsorthatfailbecauseofhavingchosenaninappropriatecapitalstructure.1Accordingly,we measuretheeffectsofleverageonfirmsurvival,acquisition,andfailure.Wealsoexaminetheeffectsof leverageon(revenue)marketshareoffirms,andwelookspecificallyatasubsampleoflowleveragefirms, astheyaretheonesmostlikelytobeacquiredifthedebttaxshelterisanimportantdriveroffirmvalue. Ourmethodologicalframeworkreflectsareturntobasics.Alchian(1950)arguesthatthe deliberatepursuitofmaximumprofit(inourcase,throughchoiceofanoptimalcapitalstructure)is unrealisticasadecisionconstructsincetheinformationnecessarytoascertaintheoptimumisnot observable.Nonetheless,hereasonsthatevenifmanagerialchoicesarerandom,theenvironmentin whichfirmscompetewillidentifychoicesthathavesurvivalvalue.Stigler(1958)usesthisreasoningtotest forthepresenceofscaleeconomiesinthesteel,automobile,andoilrefiningindustries.Theunderlying

Campello(2003)studiestherelationbetweencapitalstructureandoperatingperformance.Shefindsthatduring recessionsdebtfinancinghasanegativeimpactonfirmsalesgrowthinindustriesinwhichrivalsarerelatively unlevered.Thereisnosimilareffectduringboomsorinhighdebtindustries.Campello(2006)findsanonmonotonic relationbetweendebtfinancingandcompetitiveconduct.Moderatedebtisassociatedwithsalesgainsbuthighdebt leadstoproductmarketunderperformance. 2

logicofStiglerssurvivorshipapproachisthatgoodstrategies,inthecontextofacompetitivemarket, shouldsurviveandgrowwhileothersshoulddiminish.2 WeapplythisapproachtotheU.S.oilindustry:focusingspecificallyoncrudeoilexplorationand development.Weselectedtheoilindustryforthreemainreasons:First,thereareenoughparticipantsto makelargescaleempiricalanalysisfeasible,butatthesametime,thesingleindustryfocusenablesusto examineseveralcompaniesonamicrolevel.Second,becausetheendproductisacommodity,firms competemainlyoncostand,exceptfordifferencesinprofitabilityandgrowthopportunities,thetradeoff andpeckingorderhypothesesimplysimilarityofcapitalstructureacrossfirms.Third,itisthesame industrythatwasstudiedbyModiglianiandMiller(1958)intheiroriginalstudyofcapitalstructure irrelevance.3Thenarrowfocusonoilexplorationfirmsyieldsalargesamplebutstillenablesustofully investigateeachofthefirmsinthesampleforappropriateinclusion,touseanarrowerclassificationthana 2,3,or4digitindustrycode,andtoconductalimitedclinicalanalysisonfirmswithextremecapital structures. Weusefourapproachestotesttheoptimaltradeoffhypothesisagainstthealternativepecking orderhypothesis.First,weusesinglestageprobitandmultinomialprobitmodelstotestwhetherfirm survival,acquisition,andfailureprobabilitiesareaffectedbycapitalstructure.Thesinglestagemodels enableustoexaminenonmonotonicrelationsbetweencapitalstructureandtheseoutcomevariablesbut aresubjecttochallengebecausetheydonotformallycontrolfortheendogeneityofobservedleverage ratios.Second,toconfirmthesinglestageresults,andtoallowforcrosssectionalvariationinoptimal capitalstructure,weendogenizecapitalstructureinatwostagemodel.However,becauseofdata limitations,weareunabletoinvestigatenonmonotonicrelationshipsinthismodel.Third,wetestforthe presenceofastaticordynamicoptimalcapitalstructurebyaggregatingfirmsintoleveragebaseddeciles

Itisthestrategiesthatgainshare,andnotnecessarilytheindividualfirms.Stigler(1958)aggregatesbysize,and looksataggregatedsharechangesinsizegroupings. 3 ModiglianiandMiller(1958)alsostudyelectricutilities.However,asMyers(1984)notes,regulatedfirmsare normallyabletopassthroughinefficienciesrelatedtocapitalstructure,andthusarenotwellsuitedfortestsofthe tradeoffhypothesis. 3

andtestingwhetheraggregatedmarketsharechangesarerelatedtofactorsthatcouldaffectoptimal capitalstructureunderthetradeoffhypothesis.Fourth,weundertakeabriefclinicalstudyoffirmswith persistentlowleveragetogainabetterunderstandingofhowlowleveragecanpersistovermanyyears. Leveragemeasuresvaryacrossstudies.Atoneextreme,Lemmon,Roberts,andZender(2008), DeAngeloandDeAngelo(2007),andothersdefineleverageinawaythatemphasizesthepotentialtax advantageofdebtfinancing.Theymeasureleverageastheratioofinterestbearingdebttototalassets. Implicitly,spontaneousfinancingandnoninterestbearingliabilitiesareinterpretedtoreduceleverage.At theotherextreme,BakerandWurgler(2002)andothersdefineleverageinawaythatemphasizes informationasymmetry.Theyincludepreferredequityinleverageandexcludeconvertibledebt.4Other studiesuseintermediatemeasures.FamaandFrench(2005),forexample,defineleverageastotal liabilitiestototalassets.Welch(2011)alsoarguesforthismeasure,notingthatithastheadvantageto treatingbothfinancialandnonfinancialliabilitiesaspriorclaimstoequity.Inthisstudy,wereportresults forthetwoextrememeasures,which,forconvenience,werefertoastheLRZandBWmeasures.Wealso assesswhethertotalliabilitiestototalassets(whichwerefertoastheWmeasure)producesmaterially differentresults.TheWmeasureresultsarediscussedbutnotreportedexceptindescriptivestatistics tables.Generally,theresultsareconsistent,butsomewhatstrongerfortheBWmeasurethanfortheLRZ measure.TheWmeasureresultsaresimilartothoseforBW. UsingtheBWleveragemeasureintheprobitanalysis,firmswithhighbookormarketleveragein oneyeararesignificantlymorelikelythanotherstobedelistedfromCompustatinthenext.Delistingcan beduetoeitheracquisitionorfailure,bothofwhichprobabilitiesaresignificantlyhigherforfirmswithhigh leverageintheprioryear.Therelationshipstodelistingandfailurearenonlinear,withfailureprobability increasingdisproportionatelywithleverage.Therelationshiptoacquisitionprobabilityisnonmonotonic,as wealsofindthatfirmswithextremelowleveragearesignificantlymorelikelytobeacquiredinthe subsequentyear.UsingtheLRZmeasure,thesignsoftheserelationshipsarethesame,butonlythe
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AppendixBprovidesformaldefinitionsoftheleveragemeasures. 4

delistingandfailureprobabilitiesaresignificantlyrelatedtoleverageintheprioryear.Thedifferencein findingsmakessensebecausetheLRZmeasureisalesscomprehensiveindicatorofdepletionoffinancial slackbutapotentiallybettermeasureofexposuretodefaultrisk. Whiletheseresultsseemtosupportoptimaltradeoff,leverageintheyearbeforedelistingisnota reliablemeasureofcapitalstructurepolicy.Wefindthatleverageratiosincreasemateriallyintheyears justpriortodelisting.Usingleveragefromthreeyearspriorasanindicatorofcapitalstructurepolicy,and controllingforleverageintheyearbeforedelisting,wefindnosignificantsupportfortheoptimaltradeoff hypothesis.Rather,theevidenceshowsthatleverageincreaseswhenfirmsareintroubleformore fundamentalreasonsorwhenthefirmisgrowingrapidly,aresultmoreconsistentwiththepeckingorder hypothesis. Inthetwostageresultswithendogenouscapitalstructurethatusecorporatetaxrates,oilprices, and/orlagsoffirmcharacteristicsasinstruments,weconfirmtheabovefinding,inthatwefindthatcapital structurepolicyisnotsignificantlyrelatedtosurvivalprobability.5Thisconclusionholdsregardlessof whichmeasureisusedandwhetherleverageisexpressedasbookvalueormarketvalue. Wealsofindthatneithercontemporaneousnorlaggedleveragemeasuresaresignificantin explainingchangesinrevenuesharesofleveragedecilesovertime.Intheclinicalportionofouranalysis, wefindthatfirmscanoperateformanyyearswithlowleverage,highprofitability,andahigheffectivetax rate,suggestingthatanydisadvantagesofveryhighleveragearenotsufficienttotriggercontrolevents. Thus,thefirmstaxbasedcapitalstructurepolicydoesnotappeartobeofmuchimportanceto survival.Firmswithattractivegrowthoptionsandthosethatneedcashtofundtheircontinuing

Similarly,Wintoki,Linck,andNetter(2012)examinecausalrelationbetweenboardstructureandfirmperformance andfindnosignificanteffectofboardstructure,aresultinconsistentwithearlierfindingsthatdonottakeaccountof endogeneity.Theyapplyadynamicpanelgeneralizedmethodofmoments(GMM)estimatorthatreliesoninternal instrumentssuchaslaggedvariablesthatallowsadynamicrelationshipbetweenperformanceandcorporate governance.Ourapproach,whichalsoreliesonlaggedvariables,issomewhatdifferentbecauseourdependent variableisbinary. 5

unprofitableoperationsturntodebtfinancingwithlittleapparentregardtotaxconsiderations.6Those withattractivegrowthopportunitiesmayturntoacquisitionasinternalfinancialslackisdepleted.Overall, ourcapitalstructurepolicyresultsareconsistentwiththeirrelevanceargumentsofMiller(1977)and DeAngeloandMasulis(1980),andwiththepeckingorderhypothesisofMyers(1984).Theresultssuggest thatcapitalstructurepolicydoesnotsignificantlymattertothesurvivalofthefirmsintheoilindustry. Thebalanceofthepaperisorganizedasfollows.Section2discussesthepriorempiricalevidence

oncapitalstructure,whileSection3developsourtestablehypothesesbasedontheStigler(1958) survivorshipapproach.Section4describesthedataandSection5presentstheempiricalanalysisand results.Section6concludes. 2. PriorEvidenceonCapitalStructure Forthemostpart,empiricalresearchershavesoughttotestthecompetingcapitalstructure

hypothesesbyobservingwhatmanagersdo.Dotheyappeartoselectcapitalstructureinamannermore consistentwithoptimaltradeofforwithpeckingorder?Despitedecadesofempiricalresearch,thereis littleagreementastowhattheevidencemeans.FamaandFrench(2002)observethatmanyofthe predictionsofthetwotheoriesagreeandthatevidenceisgenerallyconsistentwiththesharedpredictions sothattheresultsarenotdispositive. LearyandRoberts(2010)pointtoconflictinginterpretationsoftheevidence.Theynotethat ShyamSunderandMyers(1999)claimtofindthatfinancingpatternsareconsistentwithpeckingorderbut thatFrankandGoyal(2003)claimtheopposite.7LearyandRobertsalsonotethatwhileLemmonand Zender(2008)concludethattheirevidencesupportsthemodifiedpeckingorderinterpretation,Famaand French(2005)findthatpeckingordercannotexplainpersistentlowleveragepolicies.
Underthetradeoffhypothesis,firmswithpositiveincometaxliabilitiesinagivenyearmightbeexpectedtorely moreonconvertibledebtfinancingandotherfirmsmightbeexpectedtorelymoreonpreferredstock.In40%ofthe firmyears,observationsinoursamplereliedonconvertibledebt,preferredstock,orboth.Wefoundnosystematic relationbetweenthechoiceoffinancingandthefirmstaxliability.Infact,financingchoicesthatwereinconsistent withthetradeoffhypothesisweresomewhatmorelikelythanthosethatwereconsistentwithit. 7 ThesestudiesalluseleveragemeasuressimilartotheLRZmeasure. 6
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Thereare,moreover,importantregularitiesthatdonotappeartofiteithertheory.Minton

andWruck(2002),forexample,usingtheLRZmeasure,findpersistentunderleveragerelativeto thetradeoffhypothesis.However,ShivdasaniandStefanescu(2010)reportthatoncepensions areconsidered,firmsarelessconservativeintheirchoicesofleveragethanpreviouslythought, andthattheyincorporatethemagnitudesofpensionliabilitiesintheircapitalstructuredecisions.

AmongtheMintonandWruckfindingsarethatlowleveragefirmshavehighmarkettobook valueratios,thatthephenomenonisnotspecifictoparticularindustries,andthatthefirmsdonothave lowtaxrates,highnondebttaxshelters,orsevereinformationasymmetries.Theevidenceoflowleverage andnoleveragefirmsseemstobeparticularlyinconsistentwiththetradeoffhypothesis.However,the evidencethatfirmssometimeschooseequityissuesevenwhenequityisnotthelastresorthasledFama andFrench(2005)toconcludethatpeckingorder,asastandalonehypothesis,isdead. BakerandWurgler(2002)andKorajczykandLevy(2003)findthatfirmsissueequitywhenmarket valuesarehigh.8Attemptedmarkettimingaffectscapitalstructurebecause,BakerandWurglerfind,low leveragefirmsarethosethatraisedfundswhentheirmarketvaluationswerehigh,whilehighleverage firmsarethosethatraisedfundswhentheirmarketvaluationswerelow.Capitalstructure,then,isthe cumulativeoutcomeofpastattemptstotimethemarket.Intheirview,attemptedmarkettimingisan additionalconsiderationintherealcapitalstructurechoicesoffirms.9 Ofcourse,thevalidityofbasinginferencesabouttheeconomicsofcapitalstructurechoiceon observationofmanagerialdecisionsisonlyvalidifthechoicesactuallymatter.Adoptingtheterminologyof evolutionarybiology,Miller(1977)referstoneutralmutationasadaptiveorimitativebehaviorthatserves nousefulpurpose,butalsodoesnoharm.Ifmanagersbelievethereisanoptimalcapitalstructure,when, infact,thereisnone,theirchoiceswillappeartosupportoptimaltradeoff.Iftheybelievesignificant adverseselectioncostsareassociatedwithraisingriskierformsofcapital,theirchoiceswillappearto
ThemeasureusedbyKorajczykandLevyissimilartotheLRZmeasure. Relatedtothis,Welch(2004)findsthatfirmsdonotrepurchasedebtandequitytocounteractmechanisticeffectsof stockmarketperformanceonmarketvaluecapitalstructure.
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supportpeckingorder.And,ifmanagersthinktheycantimethemarket,theevidencewillsupport attemptedmarkettiming.Theupshotisthatwhilemanagerialchoicescantelluswhatmanagersbelieve, theycannotnecessarilytelluswhatistrueabouttherelationshipbetweencapitalstructureandvalue. Onlyifcapitalstructurereallydoesmattercanwemakethelogicalleapfrommanagerialchoiceto hypothesisvalidity.If,inreality,thereisnomaterialcostofoperatingwithacapitalstructurethatiswell awayfromtheoptimum,thenthechoicessimplyreflectneutralmutation/imitation.Thesameistrueif managersincorrectlybelievethatadverseselectioncostsarematerial,orthattheycantimethemarket. Severalstylizedfactssupportthenotionofneutralmutationandcapitalstructureirrelevance.For example,leverageratiosvarycrosssectionallybutarequitestableovertime.Lemmon,Roberts,and Zender(2008)findthatleverageratiosarecharacterizedbybothatransitoryandapermanentcomponent. Theyfind,further,thatknowndeterminantsofcapitalstructuredoapoorjobofexplainingheterogeneity inleverageratios.Theyalsofindthatleverageratiosconvergeovertime,movingtowardmoremoderate levelsbutarequitestableoverlongperiods.Therefore,theyargue,anyexplanationofcapitalstructure mustbereconciledwiththeconverging,butlonglivedstabilityofleverageratios.Persistenceofextreme leverageratiosisanaspectofourempiricalanalysis. GrahamandLeary(2011)reviewtheliteratureandevidenceoncapitalstructureandquestion whethercapitalstructureeffectsareeither(i)importantbutnotdetectedinempiricalstudiesor(ii)the evidenceisconsistentwithneutralmutationexceptinextremecases.Theyfindthatmostofthevariation inobservedcapitalstructuresiswithinindustryvariation,asopposedtowithinfirmovertimeoracross industries.However,theyalsofindthatstandardvariablesusedtoexplainobservedcapitalstructureshave littleabilitytoexplainwithinindustryvariation.Theyalsoobservethatthevalueeffectsofcapitalstructure choicesappeartobemodestoverabroadrange.Ourevidenceisconsistentinsupportingneutralmutation andthepeckingorderhypothesis. 3. TestableHypotheses
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Nopreviousstudy,toourknowledge,hasfocusedontherelationshipbetweencapitalstructure choiceandsurvivalprobability.Ifthereisaneconomicallyimportantoptimalcapitalstructure,wepresume thereissomecommonalitywithinanindustryintermsoftheimportantfactorsthatinfluencetheoptimum. Indeed,FrankandGoyal(2008)findthatindustryisoneofthemostreliablefactorsexplainingthecapital structurechoicesandthatindustrysubsumesanumberoffactorsthatareoflesserimportance.Onthe otherhand,MintonandWruck(2002)findthatfinancialconservatismisnotanindustrybased phenomenon,sothatcapitalstructureextremescanexistwithinindustriesandGrahamandLeary(2011) observethatwithinindustryvarianceofcapitalstructureishighandhardtoexplainempirically. Inaspiritsomewhatsimilartoourapproach,Korteweg(2010)estimatesthebenefitsofleverageby assumingthatassetbetasarecommonwithinanindustry.LearyandRoberts(2010)findthatindustryand yearfixedeffectsalonedoagoodjobofexplainingleveragechoices.Lemmon,Roberts,andZender(2008), however,findthatcontrollingforstandardfactorsincludingindustryleavesmostofthevariationincapital structureunexplainedanddrivenbyunobservableeffectsthataretimeinvariant. Wecontrolforindustryeffectsthroughsampleconstructionandforotherstandardfactorsby inclusionofcontrolvariables.Itisnotnecessarythatwefullyaccountforthefactorsthatdetermine optimalcapitalstructure.Rather,inoneofourapproaches,werelyontheBayesianreasoningthat,ifan economicallyimportantoptimumexists,thenfirmswithverylowleveragerelativetotheaveragearemore likelytobeunderleveredthanoverlevered,andtheconverseforfirmswithveryhighleverage.Ina secondapproach,weendogenizecapitalstructurepolicyandtestwhetherthepolicyissignificantlyrelated tosurvivalprobability.Inthefirstapproach,ifthetradeofftheoryiscorrect,weshouldfindthatfirms withextremecapitalstructuresare(i)morelikelytobecometargetsortofailand/or(ii)morelikelytobe insulatedfromthecontrolmarketandproductmarketcompetitioninvariousways,and(iii)havea tendencytoregresstowardthemean.Ifcapitalstructureisirrelevant,weshouldfindthatcapitalstructure policyisnotsignificantlyrelatedtosurvivalprobability.Regressiontowardthemeancouldoccurevenif capitalstructuredoesnotmatter,ifthereareimportantfrictionstoraisingcapitalorifmanagersbelieve,
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incorrectly,thatcapitalstructureisimportant.Inthesecondapproach,ifthetradeofftheoryisincorrect weshouldfindlittlerelationbetweenendogenizedcapitalstructureandsurvivalprobability. Onemightthinkthatifcapitalstructureisimportantweshouldfindlittlewithinindustryvariation. Yet,wedonotseesuchevidenceintheexistingliterature.Possibleexplanationsarethatcapitalstructure isnotveryimportant,thatevenwithinanindustrytherearesubstantialdifferencesinwhatwouldbe optimal,orthatfirmswithsuboptimalcapitalstructuresareinsulatedfromcompetition.Toaddressthis, ourpaneldatastudyincludessomeclinicalstudydetailsasoverlay. 4. 4.1 DataandSummaryStatistics Data Intheiroriginal1958paper,ModiglianiandMillersupporttheirirrelevancepropositionwith

evidencefromtwoindustries,includingoilcompanies.Theypresentevidencethattheaftertaxrateof returnisinvarianttoleverage.Wefollowtheirexample,byalsofocusingonoilcompanies.Theindustry hastheadvantageofincludingalargenumberofcompanieswithpubliclyavailabledata.Becausethe industryincludesanarrayofactivities,welimitthestudytocrudeoilexplorationanddevelopment (explorationfirms). Toidentifyfirmsforinclusioninthesample,wefirstidentifyallCompustatfirmsclassifiedintheoil

industryonthebasisofcurrentorhistoricalSICcodes,currentorhistoricalNAICScodes,S&PGlobal Industrycodes,ortheformerS&Pindustrycodes.AppendixAliststhecodesweusetoconstructtheinitial sample.Afirmistentativelyincludedif,inanyyearfrom1950through2007,itisclassifiedintoanyofthe codeslistedintheappendix.Fromthissample,weexcludeallnonUSfirms. Theindustrycodessometimesidentifyfirmsthatarenotappropriatelyclassifiedasbeingintheoil industry.Theseinclude,forexample,pipelinefirms,chemicalfirms,ethanolproducers,andfirmsinvolved primarilyinmineralsmining.Byinspection,weexcludethesefirms.Wealsoexcludeoilroyaltytruststhat areincludedintheCompustatdatabase.Fromtheremainingsample,weexcludeenterprisesforwhichno

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stockpriceinformationisavailable,suchasdivisionsofpubliccompanies.Becausesomeofthe observationsareforsmallfirmsforwhichdetailsoffinancialinformationoftenarenotavailable,we imposethescreenthatforinclusioninthefinalsampleafirmmusthaveatleast$25million(inrealyear 2000dollars)oftotalassetsintheyearofitsfirstmarketpriceobservation. Next,weusethebusinessdescriptionsfromCompustat,Factiva,andInternetsearchestoverifythe scopeofactivityofeachfirm.Basedonthesesearches,weclassifyfirmsaseitherexplorationfirmsor refiners.Whenwecannotverifytheactivityofthefirm,wedropitfromthesample. BecauseofconcernsaboutsurvivorshipbiasintheearlyCompustatdata,wefurtherlimitthe sampletofirmyearsfrom1970on.10Finally,wedroprefinersbecauseofthesmallsamplesizeofthat group,theirfundamentaldifferencefromexplorationfirms,thelimitedvariationintheircapitalstructures, andthenearabsence(oneobservation)offailures.11Thus,thefinalsampleincludes218exploration firmscomprising2015firmyears. 4.2. SummaryStatistics Anobservationinourpanelisafirmyear.Table1providesdescriptivestatisticsonsamplefirms. Explorationfirmshaveanaverageof9.2yearlyobservations.Ofthesefirms,welloverhalfareacquiredor failduringoursampleperiod;53.7%(117firms)areacquiredand18.8%(41firms)failviabankruptcy, liquidation,orotherdelistingfromCompustat.Normally,firmsaredelistedwhentheynolongermeetthe requirementsforcontinuedexchangelistingandmayeventuallyfail.Whileacquisitionismorelikelythan failure,anumberoftheacquisitionsoccurinthefaceofwhatappearstobeimminentfailure.Insuch cases,werelyontheCompustatandCRSPdeletioncodesandwheretheyaredifferentwereviewFactiva todeterminetheclassification.

Kotharietal.(1995)discussthepotentialsurvivalbiasissueinearlyyeardataofCompustat. ForsomefirmstherewasinconsistencyinidentitychangesbetweenCRSPandCompustat.Wesearchedfor informationonthesecasesusingFactivaanddeterminedwhethertherehadbeenafundamentalchangeinidentity suchasacquisitionbyanotherfirm.

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Table2showsthetimeseriesdistributionoffirmyearobservations.Thenumberofexploration firmsrosesharplyduringtheperiodaroundthefirstOPECoilshock,andthentheindustryexperienceda waveoffailuresandconsolidationduringthe1980s.Thetableshowsincreasingnumbersoffirmsthrough themid1990s,followedagainbyconsolidationandattrition. Figure1isatimeseriesplotofmarketshares,aggregatedintodecilesbasedonBWbookleverage ratioswithconstantdecilebreakpointsdeterminedoverallobservations.Becausewefindthatbook leverageincreasesendogenouslypriortodelisting,thefigureisbasedonbookleveragemeasuredthree yearsbeforethemarketshareobservationyear.12Adecilecangainshareiffirmswithinthedecilegain shareoriffirmswithhighsharesmoveintothedecileandthosewithlowsharesmoveout.Patternsof dynamicallyshiftingmarketsharesbydecilearesimilartothoseshowninFigure1if(i)decilebreakpoints areallowedtovaryannually,(ii)leverageismeasuredinthesameyearasmarketshare,or(iii)theLRZ measureisusedinstead. Itisnoteworthythatfirmsinthebottomleveragedecileconsistentlyaccountforasmallfractionof thetotalmarketandthatinmostyearsthehighestleveredfirminthisdecilehasaleverageratioofless than18.0%.FromFigure1,systematicshiftingofmarketsharesamongdecilesisapparentovertime. Firmsinthebottomfivedecilesaccountforalmosthalfofthetotalmarketduringthefirstfouryears,upto thepointofthefirstOPECoilpriceshock13.Followingthat,formostofthenextthreedecades,firmsinthe topfewleveragedecilesaccountforroughly80%ofthemarket.Inlateryears,firmswithlowleverage accountforanincreasinglylargeshareofthemarket.Giventheseshifts,onemightinferthatmanagersof largerfirmsactasifthereisanoptimalcapitalstructurethatvariesovertime.Alternatively,consistent withthepeckingorderhypothesis,aggregatecapitalstructurechangesmaybedrivenbychangesinthe

AllaccountingvariablesusedintheanalysisaredefinedinAppendixB. ThecorrespondingLRZbasedfigureshowslowleveragefirmswithasmallmarketshare,exceptinthefirstfew years(whenthesamplesizeissmall);thehighestleveredfirminthelowleveragedecilehavingaLRZbookleverage ratioof2.3%;andfirmsinthebottomfiveleveragedecilesaccountingforabout40%ofthemarketduringthefirstfive years,beforedecliningtoamuchlowerpercentage.

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valueofinvestmentopportunitiesandnetcashflow.Itremainstobeseenwhethercapitalstructure choicesaresignificantlyrelatedtosurvivalprobability. 5. 5.1. EmpiricalResultsandDiscussions BivariateTestsofDifferences Wehypothesizethat,ifthereisanimportantoptimalcapitalstructureweshouldfindthatfirms locatedclosetotheoptimumflourishwhileotherssubsist,fail,orareacquired.InTable3,wereport summarystatisticsanddifferencetestresultsforsampleexplorationfirms.Thetablecomparesleverage ratiosandotherfirmcharacteristicsamonggroupsthatsurvived(groupA),wereacquired(groupB),and failed(groupC).Inthetable,wetestwhetherfirmyearobservationsintheyearpriortoacquisitionor failurehavedifferentcapitalstructuresthanfirmyearsassociatedwithsurvival.Wealsotestwhether acquisitionorfailureisrelatedtofirmsize,profitability,markettobook,tangibilityofassets,orcashflow volatility.Thepvaluesinthetablearereportedfirstbasedonthestandarderrorsforallobservations,and secondwithclusteringbyfirm.Clusteredtestsgenerallyhavesimilarsignificancelevelstothosewithout clustering,indicatingthatwithinfirmvarianceissimilartooverallvariance. Thereareimportantdifferencesamongthegroups,particularlybetweenfailedfirmsandtherestof thesample.Acquiredandsurvivingfirmsaresimilarinmostrespects.Observationyearleverageratiosare notstatisticallydifferentbetweensurvivingandacquiredfirms,regardlessoftheleveragemeasureand threeyearlaggedleverageratiosaresignificantlydifferentonlyfortheWmeasure.However,observation yearandlaggedleverageratiosoffailedfirmsaresignificantlyhigherthanthoseofeithersurvivingor acquiredfirms,exceptforthelaggeddifferencebetweenthefailedandtheacquiredbytheLRZmeasure andthelaggeddifferencebetweenthefailedandthesurvivingbytheWmeasure.Thereisalsolittle differencebetweenobservationyearleverageandthreeyearlaggedleverageratiosofsurvivingfirmsorof acquiredfirms,whereas,byanymeasure,thethreeyearincreaseinleverageisconsiderableforfailedfirms. Inaddition,failedfirmsaresignificantlysmallerthansurvivingoracquiredfirmsandaresignificantlyless
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profitable.Wefindthatacquiredfirmshavesignificantlymoretangibleassetsthanfailedfirms.Finally, cashflowsaremuchmorevolatileduringtheprecedingfouryearsforfailedthanforsurvivingoracquired firms.Thereisnosignificantdifferenceincashflowvolatilitybetweensurvivingandacquiredfirms. Overall,Table3suggeststhatleverageandotherfirmcharacteristicsaresignificantlydifferent betweenfailedfirmsandsurvivingoracquiredfirmsintheoilindustryandthatacquiredfirmsaresimilarto survivorsinmanyrespects.Also,whiletheoptimaltradeoffhypothesissuggeststhatleveragethatis eithertoohighortoolowcouldincreasetheprobabilityoffailureoracquisition,thestatisticsinthetable suggestthatthemainempiricalsurvivorshipeffectismorelikelytobeassociatedwithcontemporaneous leverageratiosthataretoohigh. 5.2. ComparisonStatisticsofExplorationFirmsbeforeDelisting ThereareindicationsinTable3that,byanymeasure,leverageincreasesendogenouslyasafirm

approachesfailure.Therefore,weneedtodistinguishbetweenafirmscapitalstructurepolicyand leverageincreasesthataresymptomaticoffundamentalchangesinfirmperformance.Inthesinglestage multivariateanalysis,weincludebothleverageintheobservationyear(year0)andtheleveragemeasured threeyearsprior(year3).FromTable3,thereisevidencethat,eventhreeyearsprior,leverageratiosof failedfirmsaresignificantlyhigherthanthoseofsurvivingfirms,particularlyfortheBWandWleverage measures.Thus,inclusionofa3yearlagmaynotbeanentirelysatisfactorywaytoassesstheeffectof leveragepolicyforfailedfirms.Toinvestigatefurther,inTable4weprovidecomparisonstatisticsfor acquiredandfailedfirmsinthelastyearbeforedelisting(year0)andthethreeprioryears,aswellas comparisonstatisticsforallotherfirmyearsinthedatabase(allsurvivoryearsandyearsbeforeyear3for acquiredandfailedfirms).Table4statisticsaredifferentfromthoseinTable3becauseTable4isbasedon onlyobservationswhereatleastfouryearsofdataareavailable,sothatyeartoyeardifferencesarefroma consistentsample. Wefindthatacquiredfirmsaresmallerthantheoverallaverage,butaregrowingrapidly(ata compoundannualrateof13.3%).Bookleverage,byanymeasure,isincreasinginthisgroupbecauserapid
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growthintheyearsbeforeacquisitionisfinanceddisproportionatelywithdebt.Marketandbookequity areinapproximatelyconstantproportionstoeachotherforacquiredfirms,sothatthemarkettobook ratioisstable,andmarketleverageisincreasingsimilarlytobookleverage. Whilesalesrevenueoffailingfirmsisgrowingovertheyearsbeforefailure(atacompoundannual rateof6.8%),operatingcashflow(EBITDA/TotalAssets)isdeclining,andisnegativeonaverageinthelast twoyearsbeforetheyfail.Bookequityalsoisdecliningandisnegativeonaverageintheyearbefore failure;infact,36%ofthefailingfirmsreportnegativebookequity.Insummary,theleverageincreasesof failingfirmsareassociatedwithpooroperatingperformance.Leverageratiosareincreasingbecauseequity isdeclining,andfirmsarecoveringoperatingneedsbyborrowing.Thesefirmsappeartobeonacourseto failure. Forthequestionofwhetherlaggedleverageratiosarereasonableindicatorsofcapitalstructure policy,Table4showsthatbothbookandmarketleverageaveragesoffailedexplorationfirmsinyear3are stillabovetheaveragesofotherfirmyearobservations.Forexample,BWbookleverageoffailedfirms averages120.3%intheyearbeforefailure(i.e.,inyear0),and69.9%inyear3,whereastheaverageof survivorobservationsis48.6%.Thesimilartrendinthe3yearlagofbookleveragesuggeststhat69.9%in year3isabovethecapitalstructurepolicychoiceoffirmsthatfailwithinfouryears.Inthefailedfirm sample,the3yearlagofBWbookleverageincreasessubstantially,to69.9%from49.2%inyear3,whichis closetotheaveragevalueofsurvivingfirms. Weinferthatthe3yearlagvaluesofleveragearealsoaffectedbytheunderlyingphenomenathat drivethesefirmstowardfailure.Becauselaggingformorethanthreeyearswouldresultinlosingmany observations,wedonotpursuethisapproachtoassessingtheeffectofcapitalstructurepolicy. 5.3. LeverageEffectsonFirmSurvivalProbability

5.3.1. Monotonicprobitanalysis GiventhedifferencesinmeansfromTable3,wefirstentertainthehypothesisthatthereisan empiricalmonotonicrelationshipbetweencapitalstructureandtheprobabilityofdelisting,acquisition,or

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failure.Toinvestigatetheeffectsofleverageonsurvivalprobability,weuseprobitmodelsoffirmyear observationsinapanel,wherethedependentvariableissettozeroifthefirmsurvivesthenextyearand oneifitisdelistedduetoeitheracquisitionorfailure.Tohelpdistinguishbetweencapitalstructurepolicy andleverageincreasesthataresymptomaticofmorefundamentalchanges,weincludebothleveragein theobservationyearandleveragemeasuredthreeyearsprior.14 Becausethedistributionofleverageratiosisskewedandweareinterestedinbothhighandlow leverageextremes,weusethenaturallogoftheratiointhemultivariateanalysis.Inthesample,1.2% (4.1%)oftheobservationshaveBWbookleverageratioslessthan5%(10%)and4.5%haveratiosgreater than100%(negativebookequity).FortheLRZmeasure,whichisalmostalwayslowerthantheBW measure,10.3%havebookleverageratiosbelow5%and9.8%haveleverageratiosabove60%.The percentagesaresimilarforleverageratiosmeasuredinyear3. InTable5probitmodels,weclassifyfirmyearobservationsasdelistedaftertheobservationyear orsurvived.Weregressthebinaryoutcomevariablesonthelogofthefirmsbookormarketleverageratio intheobservationyearandtheleverageratiothreeyearsprior.Themodelsincludestandardcontrolsin capitalstructureestimationintheliterature:firmsize(naturallogoftotalassets),profitability(operating incomebeforedepreciation/booktotalassets),markettobookassetsratio,tangibilityoffirmsassets,and cashflowvolatilityoverfouryearsendingwiththeobservationyear.15Wealsoincludeanindicator variablethatisequaltooneiftheobservationisfrombefore1978becauseofthepotentialforsurvival probabilitiesbeforethentobeaffectedbylookbackbiasinCompustatdata.16EstimatesinPanel(a)are basedonBWbookleverage;thoseinPanel(b)arebasedonLRZbookleverage,andthoseinPanel(c)are

Wealsoestimatedahazardmodelrelatingfailuretocapitalstructureinearlieryears.Becausewefindno significantrelationshipsoffailureprobabilitytopriorcapitalstructures,andbecausemanyfirmsareonlyinour sampleforafewyears,resultsaresimilartotheprobitresults.Accordingly,wedonotreportresultsforthehazard model. 15 Totheextentthatthesecontrolsexplainvariationsincapitalstructureinoursample,thepartialeffectsofcapital structurecoefficientswillreflectdeviationsfromtheoptimum.However,regressionmodelsofcapitalstructureon thesecontrolshavelowexplanatorypower,asinearliercitedstudies. 16 Shanken,Kothari,andSloan(1995)documentthepotentialforlookbackbiastoaffectCompustatdatapriorto 1978. 16

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basedonBWmarketleverage.17Allpanelsincludetheresultsofalternativespecificationswherewe replacethelaggedleveragevariablewiththethreeyearchangeinleverageandwherewereplaceboth variableswiththethreeyearchangeandthelaggedleveragevariable.Coefficientsonothervariablesare identicaltothosereportedandaresuppressedinthetable.TheresultsinTable5enableustoassessthe adequacyofusingthe3yearlagtocontrolforcapitalstructurepolicy,andtocontrastresultsforBWand LRZbookleverageandformarketleverage.Marginaleffectsarereportedinthetabletoaid interpretation.18Standarderrorsareclusteredbyfirm.19 InPanel(a),delisting(nonsurvival)ispositivelyandsignificantlyrelatedtoBWbookleveragein year0.Therelationshiptolaggedleverageismarginallysignificantbutnegativelysigned.InPanel(b),the LRZleveragemeasureshavethesamesignsasthoseinPanel(a),butarenotstatisticallysignificant.In Panel(c),themarketleveragemeasuresusingtheBWdefinitionyieldresultssimilartothoseinPanel(a). Whenwereplacelaggedleveragewiththe3yearchangeinanypanel,thesignreverses,andthenon laggedcoefficientisweaker.Whenwereplaceleverageintheobservationyearwiththe3yearlagged value,boththelevelandchangearepositivelysignedandtheBWmeasuresaresignificant. TheBWdelistingresultssupporttheendogeneityargument.Oilexplorationfirmsaremorelikely tobedelistedwhentheyarehighlyleveredandwhenhighleverageisarecentphenomenon.TheLRZ resultsindicatenosignificantrelationshipbetweencapitalstructureanddelisting,suggestingno economicallyimportantrelationshipbetweenleverageandfirmsurvival.Alldelistingresultsare inconsistentwiththehypothesisthatapolicyofhighleverageispositivelyrelatedtodelistingprobability. Rather,theevidenceindicatesthatleverageratiosincreaseendogenouslypriortodelisting.The differencesbetweenourBWandLRZresultsindicatethatthefindingsinsomeotherstudiesmaybe sensitivetohowleverageismeasured.Wealsofindthatdelistingismorelikelyforsmallerfirmsandthose withhigherratiosoftangibletototalassets.

17 18

TheprobitandmultinomialprobitresultsusingtheWmeasurearesimilartotheBWresultsinPanel(a). Theprobitmarginaleffectestimatesaresimilartoestimatesobtainedfromlinearprobabilitymodels. 19 Significancelevelsarenotmateriallydifferentifrobuststandarderrorsareusedwithoutclustering. 17

TheevidenceinTable5isinconsistentwiththerebeingarelationbetweensurvivalandcapital structurepolicy.Whencurrentleverageisincluded,laggedleverage,asameasureofcapitalstructure policy,isnotpositivelyrelatedtodelistingprobability.Toassesstherobustnessofthisconclusion,wetried includingshortandlongterminterestratesasadditionalcontrols.Thosecontrolswerenotstatistically significantatevenlowlevelsandtheresultsfortheothervariableswerenotmateriallydifferentfrom thosereported.Wealsotriedaddingannualfixedeffects.Again,resultswerenotmateriallydifferent.In thenextsubsection,weformallymodelandendogenizeleveragepolicyasanalternativetestofthe hypothesis. InthelasttwocolumnsofTable5,weusemultinomialprobittotestseparatelyforrelationships betweencapitalstructureandeitheracquisitionorfailure.ResultsbasedonBWbookandmarketleverage are,again,similar.TheLRZresultsareweakerbuthavethesamesigns.BasedmainlyontheBWmodels, currenthighlevelsofdebtfinancingareassociatedwithhigherprobabilitiesofbothacquisitionandfailure. However,resultsforthe3yearlaggedleverage(or3yearchange)aredifferent.Acquisitionsaremore likelywhenleveragehasbeenincreasingrapidly,whereastherelationshipstofailureprobabilityarenot significant.Foracquisitions,theevidencesuggeststhatitisnotsomuchthelevelastherateofchangein leveragethataffectsacquisitionprobability.ResultsfortheWmeasure(notreported)aresimilar. GiventheevidenceinTable4,thatthetotalassetsandsalesrevenueofacquiredfirmstendtobe growingrapidly,weinferthatacquisitionprobabilityisconsistentwiththepeckingorderhypothesisfirms withgoodgrowthprospectsfirstfinancewithlowriskborrowingandthenturntootheralternatives.Firms withgoodgrowthprospects,andthathavelimitedfinancialslack,appeartobecomeprospectsfor acquisition.ThisinterpretationisreinforcedbythecloseralignmentoftheBWmeasurewithfinancialslack, coupledwiththestrongerresultswhentheBWmeasureisused.TheweakerresultsfortheLRZmeasure, whichismorecloselyalignedwiththetradeoffhypothesis,reinforcetheinterpretationthatacquisition probabilityisnotdrivenbysuboptimalcapitalstructurechoicesunderthetradeoffhypothesis.

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Theevidencesuggestsadifferentinterpretationforfailedfirms.Table4showsrapidincreasesin leverageanddecreasingprofitability.BoththeBWandLRZresultsinTable5showthatthecurrenthighly leveredcapitalstructureissignificant,butthattherateofincreaseisnot.Theevidencethatlaggedcapital structureisnotsignificantandthatthechangeisalsonotsignificantwhenyear0leverageisincluded indicatesthatcapitalstructurepolicydoesnotaffectfailureprobabilitydirectly,butonlydoessoifthefirm getsintotroubleandrespondsbyincreasingleveragetounsustainablelevels. 5.3.2. Monotonicprobitwithendogenizedcapitalstructure Toassesstherobustnessofourconclusionthatcapitalstructurepolicydoesnotsignificantlyaffect

survivalprobability,weestimatetwostageprobitmodelsofendogenouscapitalstructureandsurvival probability.20Inthefirststage,weregresscapitalstructureonthesamevariablesasinTable5,butalso addthethreeyearlagsofthosevariables.Thelaggedvariablesareusedtointroducecapitalstructure policyinasimilarmannertothewaylaggedcapitalstructureisusedinTable5.Thus,whenweendogenize capitalstructureanduseitinasecondstagemodelthatincludescontemporaneousvariablesbut instrumentthelaggedvariables,thecoefficientoncapitalstructureservesasatestofwhethercapital structurepolicyissignificantlyrelatedtosurvivalprobability. Tocapturetheeffectsofgenericshocksthatmightaffectcapitalstructurebutarecorrelatedwith

survivalprobabilityonlythroughcapitalstructure,21weincludethecorporatetaxrateandthethreeyear averageofoilprices,endinginyear0.22Thetaxratesaredefinedasamarginalcorporateincometaxrate forthehighestcorporatetaxbracketintheobservationyear.Byinstrumentingcapitalstructurewiththese variables,weallowforcapitalstructuretovarywithcorporatetaxratesandoilprices.Iffirmsaddleverage whentaxratesarehigh,thecoefficientshouldbepositive.Thesignonoilpricesisambiguous.Firmsmight reduceleverageifhistoricallyhighoilpricesenablethemtopaydowndebtortheymightincreaseleverage

Wooldridge(2002,472477)providesadiscussionontheprobitmodelwithendogenousexplanatoryvariables.We alsotriedalinearprobabilitymodelby2SLSandconfirmedthattheresultswereunchanged. 21 SeeRobertsandWhited(2012)fordiscussionsonthevalidityofinstrumentalvariables. 22 Similartoourapproach,Molina(2005)usesafirmsmarginaltaxrateasaninstrumentalvariableforleveragein ordertoestimatetheeffectsofleverageoncorporatecreditratings. 19

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iftheyanticipatecontinuinghighpricesandseethisasaninvestmentopportunity.Ifchangesintaxrates andoilpricesaffectfailureprobabilitythroughcapitalstructurechanges,weshouldfindthatfailure probabilityissignificantlyrelatedtoendogenizedcapitalstructure. Table6showstwostageinstrumentalvariables(IV)resultsforboththeBWandLRZmeasuresof

capitalstructure.Inthefirstpairofmodels,bothlaggedfirmspecificvariablesandgenericshockvariables aretreatedasinstruments;inthesecondpaironlythegenericshockvariablesaretreatedasinstruments. Theserepresenttheextremesofarangeofplausibleassumptions.Wealsotriedincludingthelagged leveragevariableinthesecondstage,whereweobtainedresultssimilartothefirstpairofmodels;and excludingallofthelaggedvariablesexceptlaggedbookvaluefrombothstages,whereweobtainedresults similartothesecondpairofmodels.TheestimatesinPanel(a)arebasedonbookvaluemeasuresof leverage;thoseinPanel(b)arebasedonmarketvaluemeasures.Becausethefirststagemodelresultsin Panels(a)and(b)aresimilar,wereportthefirststageonlyforPanel(a).ModelsusingtheWmeasureof leveragearenotreported,butaresimilartothereportedresults. TheresultsinTable6areconsistentwithourinterpretationoftheresultsinTable5.Bothofthe

instrumentsarestatisticallysignificantinthefirststageequations,satisfyingtherelevancerequirementof instrumentalvariables,buttheendogenizedleveragemeasures(eitherbookormarketleverage)arenot significantinthesecondstagesurvivalmodels.23Thatis,whenwereplacecurrentyearleveragewithan endogenousmeasureofcapitalstructurepolicybasedonfirmspecificfactorsandeconomywideshocks, contemporaneousleveragebecomesnonsignificant.ThecontrastingresultsforthisvariableinTables5 and6indicatesthatthesignificantcoefficientsinTable5arisebecausenonsurvivingfirmsexperience leverageincreasesthatarenotreflectiveofthefirmscapitalstructurepolicy.

Itisknownthatinstrumentsonlyweaklycorrelatedwiththeendogenousvariablesbiastheinstrumented coefficients.Stock,Wright,andYogo(2002)suggestthattheFstatisticforthejointsignificanceofinstrumentsshould exceed10fortheestimatestobereliablewhenthereisoneendogenousvariable.InTable6,weestimateFstatistics usinglinearprobabilitymodelsforeachmodelandfindthatmostoftheFstatisticsareabove10,indicatingthatour resultsdonotsufferfromtheweakinstrumentissues.WereportKleibergenPaapFstatisticsinsteadofCraggDonald Fstatisticssinceourstandarderrorsareclusteredbyfirmsandthusthei.i.d.assumptiondoesnothold.Inaddition, accordingtothereportedunderidentificationandoveridentificationtestpvalues,ourmodelsareidentifiedandthe instrumentsarevalid. 20
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5.3.3. Nonmonotonicestimates Becausetheprioranalysiscanonlybeusedtotestforamonotonicrelationshipbetweencapital

structureandsurvivalprobabilityandweareagnosticastotheshapeoftherelationshipsbetweencapital structureanddelisting,acquisition,orfailure,weconsiderthreedifferentfunctionalformsthatallow nonmonotonicity:(1)quadraticspecificationstocurrentandlaggedcapitalstructure;(2)alinearsplined modelthatallowscapitalstructuresaboveandbelowthesamplemeantohavedifferentslopes;and(3) linearsplinedmodelswheretherelationshipsofcapitalstructuretooutcomesareassumedtobelinear overabroadrange,butallowedtobedifferentintheupperandlowerdecilesandquintiles. WereportthisanalysisinTable7.AsinTable5,wereportmultinomialprobitestimatesfor

acquisitionandfailureoutcomes.Becausecontrolvariablecoefficientsaresimilartothosereportedin Table5,wesuppresstheminTable7.Becausebookvalueandmarketvalueresultsaresimilar,wereport onlybookvalueresults.AndbecauseourstrongestresultsinTable5arefortheBWmeasure,wereport anddiscussmainlythoseresults.LRZresultsarereportedinAppendixC;WresultsaresimilartotheBW resultsandarenotreported. (a)Quadraticspecification Totestforarelationshipbetweencapitalstructureandoutcomeprobabilitythatisapproximately

quadraticinthenaturallogofleverage,inPanel(a)wetestthreealternativespecifications:squaringonly thecurrentleverageratio,onlythelaggedleverageratio,andsquaringboth.Thequadratictermforthe observationyearisstatisticallysignificantfordelistingprobability.Solvingthequadratic,however, indicatesaverylowoptimumofabout11.5%debttototalassetsinyear0.Thelowoptimumforcurrent leveragerelativetothesamplemeanhelpstoexplainthesignificantmonotonicestimatesinTable5. TherelationshipinPanel(a),whilesignificant,isweakexceptintheextremes.Basedon investigationoftheresults,delistingprobabilityincreasessubstantiallyatyear0leverageratiosabove 100%.Fromtheminimumpointtoleverageratiosofeither1%or100%,estimateddelistingprobability increasesbyabout6.7percentagepoints.Wefindnosignificantresultsforquadraticspecificationsof

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laggedleverage.ThecoefficientonlaggedleverageissimilartothatinTable5andthequadratictermis notsignificant.Resultsarenotsensitivetoinclusionofinterestratevariablesorannualfixedeffects. DelistingresultsfortheLRZmeasureofbookleveragearesimilar,exceptthatthelaggedrelationshipsare neversignificant. Foracquiredfirms,resultsarenotmateriallydifferentfrominTable5,andintroducingthe

quadratictermsmakestheobservationyearcoefficientnonsignificant.Theresultsagainsupportthe inferencethatcompellinggrowthopportunitiesthatconsumefinancialslackleadtoacquisition.The estimatedobservationyearoptimalcapitalstructureinthefailuremodelisagainlow,atabout10% leverage.Failureprobabilityincreasesbyonlyabout2.2percentagepointsascurrentleverageincreasesto 100%ordecreasesto1%.Laggedcapitalstructureisneverstatisticallysignificantinthequadraticmodels, consistentwithourfindinginTable5thatcapitalstructurepolicyisnotsignificantlyrelatedtofailure probability;failureprobabilityincreaseswhenunderperformanceleadstoleverageratiosthatarenot sustainable.LRZresultsforacquisitionareneversignificantandthoseforfailureareconsistentwithresults reportedinTable5. (b)Highandlowleveragedifferences InPanel(b),weallowtheslopeoftheleveragerelationshiptobedifferentaboveandbelowthe

samplemean.Ineachmodel,weincludethelogofbookleverageandthelaggedvalueofbookleverage. Wealsoinclude,forobservationsabovethesamplemean,eitherahighleveragevariablethatmeasures thedifferencebetweenobservedyear0leverageandthemeanandisotherwisezero,orasimilarlagged highleveragedifferencevariable,orboth. Weagainfindpositiverelationshipsofdelisting,acquisition,andfailureprobabilitiestoyear0

leverage.Therelationshipissignificantlygreaterforobservationswhereleverageisabovethemean.Both theBWandLRZresultsconsistentlyindicatethatthe3yearlaggedleverageinteractionisnotsignificant andthebase3yearlaggedresultissimilartothatinTable5,againsupportingtheviewthatacquisitions occurinresponsetorapidgrowththatisfinancedwithdebt.

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Fordelisting,themodelinTable7indicatesthatfailureprobabilityisincreasinginyear0leverage, withtheprobabilityincreasingby16.3percentagepointsasleverageincreasesfrom1%tothesample meanof42%,andbyanother9.7percentagepointsasleverageincreasesto100%.Intheacquisition model,therespectiveincreasesassociatedwithyear0leverageareestimatedtobe7.9and4.9percentage points.Similarly,inthefailuremodel,therespectiveincreasesare4.0and1.9percentagepoints.For neitheracquisitionnorfailureprobabilityisthe3yearlaggedinteractionvariablestatisticallysignificant. Overall,theseresultssupporttheinferencesfromTables5and6.Thereisnoevidencethat

delisting,failure,oracquisitionprobabilitiesincreaseforlowleveragefirmsinyear3and,basedonTable 5,thenegativecoefficientsonlaggedbookleverageareappropriatelyinterpretedasindicatingthatthe rateofchangeinleverageisassociatedwithhigheracquisitionprobabilityduetotheneedtofundgrowth. LRZresultsappeartobeweakerbecausethemeasureislesscloselyalignedwiththepeckingorder hypothesis. (c)Modelsofleverageextremes Neitherthequadraticnorthehighlowmodelscanreliablydetectwhetherextremeleverageratios areassociatedwithmateriallyhigherprobabilitiesofdelisting,acquisition,orfailure.Tocapturethe extremes,weclassifyfirmsintobookleveragedecilesorquintileseachyear.Weextendtheprobitmodels byincludinginteractionsofbinaryvariablesforthelowestandhighestleveragedeciles(quintiles)withthe differencebetweentheleverageratioandlowestobservedvalueabovethebottomquantileorbetween thevalueandhighestobservedvaluebelowthetopquantile.Alldifferencesaremeasuredasobservation valueminuscriticalvalue.Thesedifferencevariablesareconstructedforbothyear0andyear3. InPanel(c),thecontemporaneoushighleverageindicatorvariablesarestatisticallysignificantand positivelyrelatedtodelistinginbothdecileandquintilemodels.Lowleverageindicatorsarenotsignificant. ThisisalsotruefortheLRZmodels.Theresultssuggestthatfirmswithveryhighyear0leverageratiosare morelikelytobeacquiredorfail.Thereisnosignificantevidencethatfirmsaresubjecttogreaterriskof nonsurvivaliftheyoperatewithcapitalstructureswellbelowthenormsinyear0.However,acquisition
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probabilityissignificantlypositiveforthebottomdecile;whereasfailureprobabilityissignificantlynegative (bothresultsforthebottomdecilearenotstatisticallysignificantintheLRZmodelsinAppendixC).The3 yearlaggedvariablesforthehighestandlowestleveragedecilesandquintilesareneversignificant, suggestingcapitalstructurepolicyisnotimportantforfirmsurvival(alsotrueintheLRZmodels). (d)Recap Boththemonotonicandnonmonotonicspecificationsindicatethatdelisting,acquisition,and

failureprobabilitiesincreasewithyear0leverageandthereissomeevidencethattherelationshipisnot linearinthenaturallogofleverage.Wefindnoevidenceofanoptimalcapitalstructurebasedonthe3 yearlagofleverage.Thetwostageresultswithendogenizedcapitalstructureconfirmthisconclusionin thattheendogenousleveragepolicyvariableisnotsignificantlyrelatedtosurvival.Overall,theresultsare consistentwiththepeckingorderhypothesisinthatacquiredfirmsfirstusedebtcapacitytofundgrowth andthenaremorelikelytobecomeacquisitioncandidates.Thepositiverelationshipbetweenyear0 leverageandfailureprobabilityarisesendogenouslyfirmswithoperationalproblemsincreaseleveragein thefaceofdecliningperformanceandaremorelikelytofail. 5.4. LeverageEffectsonRevenueShares Researchersuserevenue(market)shareandchangeinrevenueshareasindicatorsofgoodchoices. Asnoted,Stigler(1958)arguesthatthecompetitiveprocesswillcausetheaggregateshareoffirmswith goodstrategiestoincrease,andpresentsevidencefromseveralindustries.Appel,Worrall,andButler (1985)studysurvivorshipofpropertyandliabilityinsurersinrelationtofirmsize.Bring(1982)andHibdon andMuller(1990)studysurvivorshipofpetroleumrefineryestablishmentsbyfacilitysize.Gregory(2000) usesthesurvivorshipapproachtoassessscaleeconomiesininternationallinershipping.24 Wehypothesizethatifthereisanimportantoptimalcapitalstructureforexplorationfirmsthenwe shouldfindthattheaggregaterevenueshareoffirmslocatedclosetotheoptimalcapitalstructure increasesovertime.Toassesstherelationshipofcapitalstructuretoaggregaterevenuesharewegroup
SeealsoKeeler(1989)regardingtheUStruckingindustry,DanosandEichenseher(1982)regardingtheauditing industry,andSanterreandPepper(2000)regardingUShospitalservices. 24
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firmsintodecilesbasedontheirbookleverageratiosandsumtherevenuesharesofthefirmswithineach decile.TheresultsofthisaggregationforBWleverageinyear3werepresentedearlier,inFigure1. ItisapparentfromFigure1thatifthereisanoptimalcapitalstructure,itisnotstationary. Conceivably,theoptimumisaffectedbythemainfactorsthatwouldaffectthetradeoffbetweenthedebt taxshelterandbankruptcycost.However,thedatainFigure1providenosupportforthisexplanation.In variousyears,thetophalfoftheobservationsaccountforanywherefrom9.2%to95.2%ofmarketrevenue. Basedoninvestigationoftherelationsbetweendecilemarketsharechangesandvariousmacrofactors,we findthattheperiodofhighnominalinterestratesfrom1979through1985isassociatedwithalarge marketshareforhighlyleveredfirms,butthemedianleverageratiomeasuredinthiswayincreasesseveral yearsbeforetheinterestratespikeandtheleverageratiodoesnotdecreaseafter1985,whennominal ratesdecline.Movementofthemedianleverageratioalsoisnotsensitivetoimpliedshorttermrealrates, whicharenegativefrom1974through1980andunusuallyhighfrom1981through1986.Themedian leverageratioishighandstableoverthis13yearperiod.Thereisalsonoevidencethatthemedian leverage ratio is sensitive to corporate tax rates. When the maximum corporate rate was reduced from 46% to34%aroundthetimeoftheTaxReformActof1987,thechangehadnoapparenteffectonthemedian leverageratio. Inshort,thisevidenceprovidesnosupportfortheoptimaltradeoffhypothesis,consideringeithera staticoptimumoronethatevolvesovertimeinresponsetointerestrates,inflationrates,andtaxrates. Moreover,wehavealreadydeterminedthatdelisting,acquisition,andfailureprobabilitiesarenot significantlyrelatedtointerestrates. PerhapstheshiftingmarketsharesinFigure1areattributabletothepeckingorderhypothesis.As observedearlier,firmsmayincreaseleveragetopursuegrowthopportunities,andreduceitwhentheir operationsgeneratefreecashflowthatisunneededforinvestment.Thedatainthefigureappear generallytosupportthishypothesis.Themedianleverageratioincreasedsharplyintheyearafterthe1973 OPECoilpriceshock,andremainedhighformanyyears.Afterreachingarealpriceofover$100perbarrel
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in1980,oilpricesdeclinedsubstantially.Duringthiseraoflowprices,themedianleverageratioremained high.Asrealpricesbegantoincreasearound2000,leverageratiosbegantodecline.Whilethismakesa plausiblestory,thedataaretoolimitedtoenableustoproviderigorousempiricalsupport.Wetried modelingthechangesinthemarketsharesofleveragedecilesbutwereunabletofindastationary relationshiptooilprices.Theonlyconsistentlysignificantexplanatoryvariableswerethelaggedmarket shareofthedecileandanordinaldecilerankvariable.Pricesorpricechangesinteractedwithbinarydecile indicatorswerenotsignificant.Weobtainedsimilarresultsusingleveragequintilesandusingthemedian leverageratio.25 Itisnotclearwhyincreasingoilpriceswouldtriggerleverageincreasinginvestmentinthe1970, buthighpricesinthe2000swouldtriggerleveragereduction.Tobesure,theregulatoryenvironmentnow isdifferentfromwhatitwasinthe1970sandmaybediscouragingexplorationfirmsfrominvesting. 5.5. FirmswithPersistentLowLeverage:AClinicalExamination Theoptimaltradeoffhypothesisimpliesthatfirmswithpersistentlylowleveragemaybefailingto

takeoptimaladvantageofthetaxdeductibilityofinterestexpenseand,therefore,arelikelytobe acquisitiontargets.Ourstatisticalevidencedoesnotsupportthis,andindicates,rather,thatfirmsare acquiredwhentheirgrowthprospectshavereducedfinancialslack,afindingmoreconsistentwiththe peckingorderhypothesis.Still,persistentlowleverageseemspuzzling.Perhapslowleveragefirmsare inefficientbutareinsulatedfromthetakeovermarket.Tobetterassessthis,weidentifiedfirmsinour samplethatoperatedwithpersistentlowleverageusingtheBWmeasure,andtrackedtheirperformance. Fivefirmsinoursamplehadbookleverageratiosthatwerepersistentlybelow20percent. GeneralAmericanOilCompanyoperatedwithlowleveragefrombefore1970through1980and

withoutconvertibledebtorpreferredstock.26Duringthisperiod,companyrevenuewasgrowingata

Wetestedthisatthefirmlevelbyregressingleverageonleadsandlagsofoperatingcashflow(EBITDA)andfound thatleveragechangesarenegativelyrelatedtocontemporaneousandlaggedcashflow,butnotrelatedtoleadsof cashflow.Thesefirmlevelresultsareconsistentwiththepeckingorderinterpretation. 26 Wespecificallyindicatetheuseofconvertibledebtandpreferredstockfortheselowleveragefirmsbecausethese financingsourcesareimportanttothedifferencebetweentheBWandLRZmeasures. 26

25

compoundannualrateof17.6%,andwithanunusuallyhighaverageannualEBIT/salesratioof31.4%.The companycarriedamodestleveloffundeddebtandincreaseditsdividendsatacompoundannualrateof 11.1%.Itsaverageannualeffectivetaxrateonincomeduringtheperiodwas33.2%. GeneralAmericanappearstohavebeenwellsuitedfortakeoverunderthetradeoffhypothesis.It dideventuallybecomethetargetofahostiletakeoverattempt,when,inoneoftheearliestcorporate raideractions,T.BoonePickensmadeanofferinDecember1982.PickenswasoutbidbyPhillips Petroleum,which,actingasawhiteknight,acquiredGeneralAmericanin1983.27Whiletheoutcomeis consistentwithoptimaltradeoff,ittookmorethan10yearsoflowleverageoperationwithoutapparent challengetoprecipitatethetakeoverattempt.Eitherthecontrolmarketisnotveryeffectiveatdisciplining inefficientcapitalstructurechoices,orthecapitalstructurepolicyofthefirmisnotveryimportant. MSRExplorationoperatedwithbookleveragebelow20%from1982through1989andno

convertibledebtorpreferredstock,butwithoutrevenuegrowthandwithdecliningprofitability.EBIT turnednegativein1986andremainednegativeintothemid1990s.Afterseveralyearswithoutinterest bearingdebt,thecompanybeganborrowingin1989andcontinuedintothe1990s,butthemainreasonfor increasingleveragewasdecliningequitybookvalueassociatedwithoperatinglosses.Duringthisperiod, MSRseffectivetaxratewasconsistentlyzero.ThecompanywasmergedwithQuicksilverResources,Ltd. in1999,atwhichtimeithadasignificanttaxlosscarryforward.Insummary,MSRslowleveragewasnot indicativeofanunexploitedtaxbenefitofdebtfinancing.Infact,thecompanyactuallyincreasedits borrowingforseveralyearsbeginningin1989,eventhoughitstaxliabilitywaszero.Theevidencesuggests thatMSRwasheadedforfailure,butthatmergermayhavebeenpreferablebecauseitwouldpreserve valueofassetssuchasitstaxlosscarryforward.Infact,MSRfiledforbankruptcyin1992andwas reorganized,toextendthematurityofitsoutstandingdebt.Restructuringjustpostponedfailure.The companysuseofdebtfinancingandreorganizationtosupportoperationsasperformancedeclinedis

27

Slater(1999)describesthisearlytakeoverattempt. 27

consistentwiththepeckingorderhypothesis,asraisingequityinthefaceofbankruptcywouldnothave beenfeasible. McFarlandEnergyoperatedwithbookleveragebelow20%from1976through1993.28Duringthis period,exceptfortwomodestepisodesofborrowing,includingoneconvertibledebtissueandsmallasset sales,thecompanyfundeditsoperationsinternally,byreinvestingoperatingcashflows.Operating performanceduringthisperiodwasmodestanditlostmoneyandhadanegativetaxliabilitymostyears aftertheconvertibledebtissue.Bookassetsgrewataslowcompoundedannualrateof1.2%andsales grewatarateof2.4%.Thecompanysoperatingperformancewaspoor,withanegativeannualaverage ratioofEBITtototalassets.Itsaverageeffectivetaxrateduringtheperiodwas5.6%.Overall,thereislittle tomakethecompanyattractiveasanacquisitiontargetandperformanceisnotbadenoughtothreatenits survival.From1993through1996,followingasubstantialacquisitionthatwaslargelydebtfinanced,the companysperformanceimprovedsharply.Bothrevenueandprofitabilityincreased.In1997,after agreementwithMcFarlandmanagement,MontereyResourcesacquiredMcFarlandviatenderoffer.29 StatexPetroleumoperatedwithbookleveragebelow20%inallyearsbutonefrom1974through 1982,andwithoutconvertibledebtorpreferredstock.Duringmostofthisperiod,itoperatedwithno interestbearingdebtandwasmajorityownedbyCaliforniaPortlandCementCompany(laterrenamed CalMat).Duringtheperiod,companyassetsgrewatanannualrateof15.6%andrevenuegrewat19.7%. Exceptforthelasttwoyears,theperiodofmostrapidgrowth,Statexfundeditsgrowththroughcashflows fromoperations.Inthelasttwo,itturnedtoasignificantincreaseinpreferredequity(heldbyCalMat,on whichitpaidapreferreddividend)andamodestfundeddebtissuetofinanceitsgrowth.Thecompanys averageannualratioofEBITtototalassetswas7.8%anditsaverageeffectivetaxratewas7.9%.While performancewasmodest,thecompanywasinsulatedfromthecontrolmarketbyvirtueoftheCalMat block.Inthefaceofdecliningoilpricesbeginningin1983,CalMatsolditsinterestandPSA(formerlyPacific

28 29

Oursampleperiodforthecompanybeginsin1979duetomissingdatarequiredforcompleteearlierobservations. NewYorkTimes(1997)andU.S.SecuritiesandExchangeCommission(1979). 28

SouthwestAirlines)acquiredStatexaspartofitsoilportfolio.30Statexisanotherexampleofalowleverage firmthat,undertheoptimaltradeoffhypothesis,wouldnothaveattractedacquisitioninterestbecauseof itsmodestprofitabilityandloweffectivecorporatetaxrate.CalMatonlydecidedtosellwhenthecompany becameconsistentlyunprofitable.PSAsacquisitionappearstobemoreofahedgingstrategythanan effortmotivatedbytheperceptionthatStatexwasoperatingwithaninefficientcapitalstructure. WiserOiloperatedwithbookleveragebelow20%fromatleast1970through1992andwithout

convertibledebtorpreferredstock.31Duringthis23yearperiod,totalassetsgrewatanannualrateof 6.1%andrevenuegrewat7.6%.For15years,from1972through1986,thecompanysannualEBITto assetsratioaveraged17.4%anditseffectivetaxrateaveraged42.9%.Thecompanyrefrainedfrom borrowingduringmostofthisperiodanddistributedmuchofnetincomeasdividends.Through1986, Wiserwasaclearcaseoflowleverageandhightaxes,butthecompanyissuednodebtformostofthe periodandthereisnoindicationthatitwastargetedforacquisition.After1986,oilpricesbegantodecline andWisersnetincometurnednegative.In1992,thecompanyrelocatedtoTexas,restructuredits managementteam,andbegantodivestitsunderperformingassetsanddevelopnewreserves.Beginning in1992,thecompanysleverageratioincreasedconsiderably,eventhoughitcontinuedtogenerate negativeEBITinmostyears,anditsaverageeffectiveannualtaxratewasquitelow.Theevidenceofyears ofoperationwithoutinterestbearingdebtandhigheffectivetaxratesdoesnotsupporttheoptimal tradeoffhypothesisasanimportantdriverofcapitalstructure,whereastheincreaseinleveragetofund growthwhenearningsarenegativeandtaxesarelowisconsistentwiththepeckingorderhypothesis.The acquisition,in2004,byForestOil,didtransferownershiptoahighlyprofitableexplorationfirm,wherethe attractivenessoftheacquisitioncouldhavebeenpartlytaxrelatedduetoWisershistoryoflosses. Insummary,theevidencefromthesefivecasesprovideslittlesupportfortheoptimaltradeoff

hypothesis.Somelowleveragefirmswereoperatingwithprofitratesandeffectivetaxratesthatare probablytoolowtomotivateleverageincreasingtakeoverorrestructuring.Onehighlyprofitablefirm,
30 31

LosAngelesTimes(1985). Becauseofmissingdataonsomevariables,thesampleusedinouranalysisbeginsin1972. 29

GeneralAmerican,didattractahostilebid,butonlyaftermanyyearsoflowleverageoperation.Consistent withthepeckingorderhypothesis,WiserOil,operatedforyearswithlowleverage,andonlychangedwhen continuingoperationsbecameunprofitableanditwascompelledtoundertakeagrowthstrategy. 6. SummaryandConclusions Howimportantiscapitalstructurepolicytofirmsurvival?Thisquestionhasbeenthefocusofa greatdealoffinanceresearch,butremainsunresolved.Inthispaper,weexploitthenotionthat,in competitivemarkets,firmswithcapitalstructuresclosetoaneconomicallyimportantoptimumshould performbetterandbemorelikelytosurvivethanthoselocatedfurtherfromit.Ourevidence,basedona paneldatastudyofoilexplorationfirms,indicatesthatcapitalstructurepolicybearslittlerelationshipto survivalprobability.Thisfindingisrobusttowhetherweemployaleveragemeasurethatiscloselyaligned withthetradeoffhypothesis,onethatiscloselyalignedwiththepeckingorderhypothesis,oran intermediatemeasure.Whilefirmswithveryhighleverageinoneyeararesomewhatmorelikelytofailor beacquiredinthenext,thedriversoffailureandacquisitionaremorefundamental,andalsoaffectcapital structure.Firmsthatencounteroperatingproblemsappeartoincreaseleveragetoaddresscashneedsor elseleverageincreasesbecauseofpoorperformancesothatthebookandmarketvaluesofequitydeclines. Whiletheleverageincreaseisaprecursoroffailure,therelationshipdoesnotappeartobecausallyrelated tofailureprobability.Asimilarinterpretationappliestohighleveragepriortoacquisition.Forthesefirms, theincreaseinleverageisoftendrivenbyattractiveinvestmentopportunitiesandacquisitionmaybea meansofgainingadditionalfinancialslacktosupportgrowth. Importantly,fortestingforanoptimalcapitalstructure,theeyearlaggedleverageratios,as indicatorsofcapitalstructurepolicy,arenotsignificantdeterminantsofafirmssurvivalprobability. Moreover,whenweendogenizedcurrentcapitalstructureinatwostageIVmodel,wefindthatthe endogenousestimateofcapitalstructurepolicyisnotsignificantlyrelatedtofirmsurvival.Also, contemporaneousandthreeyearlaggedleverageratiosarenotsignificantinexplainingaggregatechanges
30

inrevenuesharesoffirmsgroupedintoleveragedeciles.Thusourresultsfromcrosssectionaltestsonthe paneldataoffirmsareconsistentwithotherstudiesthatfindlittleevidenceofanimportantoptimalcapital structure.Instead,theevidencesupportsthecapitalstructureirrelevanceargumentsofMiller(1977)and DeAngeloandMasulis(1980),andthepeckingorderhypothesisofMyers(1984).Ouruseofthe survivorshipprinciple,inthespiritofStigler(1958);andourclinicalexaminationoflowleveragefirms, suggestarethinkingofthewaycapitalstructuretestsareconducted. Whilethespecificempiricalfocusofourstudyisonoilexplorationfirms,weseenoreasonthatour findingswouldnotapplymorebroadlytoallindustries.

31

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 Table1:SampleDistribution
Thesampleconsistsoffirmsinthecrudeoilexplorationanddevelopmentsectorsoftheoilindustry,withfirst years of reported stock prices from 1970 through 2007. The delisted/deleted total is the number of firms deleted from Compustat at some point after the first year of reported stock price. Deletion type is based on the first deletion or delisting code on Compustat or CRSP. Firms classified as failed include bankrupt and liquidated firms and firms delisted for other reasons. Firms delisted for other reasons normally are delisted duetofailuretomeetexchangerequirementsforcontinuedlisting.
PanelA:Numberoffirms Firmsinthesample Alldelisted/deletedfirms Acquired Failed PanelB:Numberofobservationyearsperfirm Mean 9.2 1.0 Min. 3.0 25% 7.0 Median 13.0 75% Max. 38.0 158 117 41 N 218 72.5% 53.7% 18.8% Pct. 100.0

Table2:SampleDistributionbyYear
The sample consists of crude oil exploration and development firms from 1970 to 2007. Number of firms is the number of observations for that year. Of this total, we report the number and percentage for which the observation is the first reporting year for the firm; the number and percentage for which the observation is the last fiscal year before failure; and the number and percentage for which the observation is the last fiscal year before acquisition. Failed firms include firms that are bankrupt, liquidated, or delisted for reasons other than acquisition.
Year 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Total Number offirms 14 16 32 41 48 48 44 47 51 53 53 57 62 63 59 58 52 49 50 52 57 59 56 57 63 73 79 77 77 62 57 54 51 48 45 43 51 57 2015 No. 0 2 16 10 7 2 3 5 4 4 3 6 9 8 7 4 2 3 5 4 6 7 5 2 9 14 10 6 7 3 3 2 4 1 1 2 10 8 204 Newfirms Pct. 0.0% 12.5% 50.0% 24.4% 14.6% 4.2% 6.8% 10.6% 7.8% 7.5% 5.7% 10.5% 14.5% 12.7% 11.9% 6.9% 3.8% 6.1% 10.0% 7.7% 10.5% 11.9% 8.9% 3.5% 14.3% 19.2% 12.7% 7.8% 9.1% 4.8% 5.3% 3.7% 7.8% 2.1% 2.2% 4.7% 19.6% 14.0% Firmsacquiredinthe nextyear No. Pct. 0 0.0% 0 0.0% 0 0.0% 1 2.4% 2 4.2% 5 10.4% 1 2.3% 0 0.0% 2 3.9% 2 3.8% 2 3.8% 3 5.3% 3 4.8% 7 11.1% 3 5.1% 4 6.9% 3 5.8% 4 8.2% 1 2.0% 2 3.8% 3 5.3% 5 8.5% 1 1.8% 0 0.0% 4 6.3% 3 4.1% 7 8.9% 7 9.1% 7 9.1% 9 14.5% 4 7.0% 5 9.3% 4 7.8% 4 8.3% 4 8.9% 2 4.7% 2 3.9% 1 1.8% 117 Firmsthatfailinthe nextyear No. Pct. 0 0.0% 0 0.0% 0 0.0% 0 0.0% 0 0.0% 2 4.2% 1 2.3% 0 0.0% 0 0.0% 0 0.0% 1 1.9% 1 1.8% 3 4.8% 4 6.3% 2 3.4% 4 6.9% 2 3.8% 0 0.0% 1 2.0% 1 1.9% 1 1.8% 3 5.1% 0 0.0% 3 5.3% 0 0.0% 1 1.4% 0 0.0% 0 0.0% 9 11.7% 0 0.0% 0 0.0% 2 3.7% 0 0.0% 0 0.0% 0 0.0% 0 0.0% 0 0.0% 0 0.0% 41

 Table3:SampleCharacteristicsandBivariateTests
The sample consists of firms in the exploration and development sector of the oil industry from 1970 to 2007. The table presents mean values and standard deviations (in italics) for each firm characteristic variable used in the analysis. Variables are defined in Appendix B. For Wald tests, pvalues test whether the means are statistically different among groups of firms. For the test of betweengroup differences, pvalues without clustering and with the assumption of equal variances are reported first and those with standard errors clustered by firm are reported second. Significance levels: ***,**,*are0.01,0.05,and0.10intwotailedtests.
Variable Bookleverage(BW)

Surviving firms[A] Mean [Std.Dev.] 0.497 0.318

Acquired firms[B] Mean [Std.Dev.] 0.506 0.277 0.485 0.492 0.333 0.228 0.334 0.358 0.555 0.238 0.497 0.242 0.409 0.226 0.411 0.490 5.411 1.543 0.157 0.228 1.203 0.862 0.785 0.158 0.080 0.089 117

Failed firms[C] Mean [Std.Dev.] 1.174 1.272 0.685 0.443 0.575 0.414 0.398 0.275 0.939 0.482 0.593 0.324 0.677 0.259 0.528 0.295 3.639 1.711 0.107 0.332 1.350 1.415 0.677 0.204 0.158 0.176 41

A=B=C 0.00 *** 0.00 *** 0.01 *** 0.03 ** 0.00 *** 0.00 *** 0.17 0.19 0.00 *** 0.00 *** 0.15 0.08 * 0.00 *** 0.00 *** 0.06 * 0.05 * 0.00 *** 0.00 *** 0.00 *** 0.00 *** 0.42 0.77 0.00 *** 0.00 *** 0.00 *** 0.01 ***

Testsofdifference (Notclustered/Clustered) A=B 0.81 0.76 0.65 0.72 0.58 0.57 0.61 0.69 0.81 0.78 0.09 0.04 0.54 0.56 0.94 0.96 0.69 0.68 0.07 0.18 0.92 0.93

A=C

B=C

0.00 *** 0.00 *** 0.00 *** 0.00 ***

3yearlaggedbookleverage(BW)

0.501 0.357

0.00 *** 0.00 *** 0.01 *** 0.02 **

Bookleverage(LRZ)

0.322 0.215

0.00 *** 0.00 *** 0.00 *** 0.00 ***

3yearlaggedbookleverage(LRZ)

0.321 0.261

0.07 * 0.07 *

0.19 0.24

Bookleverage(W)

0.549 0.268

0.00 *** 0.00 *** 0.00 *** 0.00 ***

3yearlaggedbookleverage(W)

0.547 0.305

* **

0.35 0.39

0.09 * 0.09 *

Marketleverage(BW)

0.396 0.223

0.00 *** 0.00 *** 0.00 *** 0.00 ***

3yearlaggedmarketleverage(BW)

0.414 0.294

0.02 ** 0.02 **

0.04 ** 0.07 *

Log(totalassets)

5.340 1.855

0.00 *** 0.00 *** 0.00 *** 0.00 ***

Profitability

0.128 0.155

0.00 *** 0.00 *** 0.00 *** 0.00 ***

Markettobookratio

1.195 0.715

0.19 0.47

0.28 0.53 0.00 *** 0.00 ***

Tangibility

0.728 0.183

0.00 *** 0.00 ***

0.08 * 0.12

CashFlowVolatility

0.072 0.088

0.32 0.34

0.00 *** 0.00 *** 0.00 *** 0.01 ***

#ofobs.

1857

Table4:ComparisonStatisticsforExplorationFirmYearsPrecedingAcquisitionorFailure
The table shows comparison mean statistics for the last four years of financial performance of exploration firms prior to acquisition or failure, relative to all firm years forsurvivingfirmsandallotherfirmyearsforacquiredorfailedfirms.Statisticsarebasedon93acquiredexplorationfirmsand25failedfirmsforwhichfourfullyears ofdataareavailablepriortodelisting.Firmswithfewerthanfouryearsofdataaredroppedfromthiscomparison.
BW BW Book LRZ Total Book Market Total Sales Book Leverage Book Assets Equity Equity Debt Revenue Leverage (lag3) Leverage Acquired Year0 Year1 Year2 Year3 Failed Year0 Year1 Year2 Year3 110.2 17.5 155.8 28.2 137.8 17.3 136.1 26.2 52.7 127.7 93.0 127.6 112.0 120.6 96.3 109.9 62.2 65.9 66.7 51.4 120.3% 81.8% 75.0% 69.9% 69.9% 64.6% 52.8% 49.2% 51.9% 44.1% 43.2% 40.8% 40.8% 37.0% 29.1% 31.0% 897.2 393.1 794.3 508.1 808.4 349.5 586.3 454.3 671.6 319.8 576.4 345.7 615.8 287.5 570.7 328.3 493.9 330.4 328.6 340.5 LRZ Book W Leverage Book (lag3) Leverage 31.6% 31.0% 29.2% 30.3% 56.5% 54.8% 52.6% 51.6% 90.6% 64.8% 62.3% 58.9% 54.7% W Book Leverage (lag3) 51.6% 52.0% 52.1% 58.2% 58.9% 59.1% 49.9% 50.6% 54.6% 64.3% 55.1% 49.7% 49.7% 49.7% 41.5% 40.0% 41.2% 39.3% 40.4% 11.14% 0.02% 6.98% 3.94% 2.98% 1.18 71.9% 6.99% 2.30% 1.40 1.30 1.42 1.33 65.2% 68.8% 70.4% 66.0% 16.65% 12.32% 10.02% 9.15% 0.28% 0.26% 0.29% 0.22% BW Tangible Cash BW Market EBITDA AssetstoFlow Market Leverage /Total Market Total Volatility Market Leverage (lag3) Assets toBook Assets (4year) Share 41.6% 40.0% 37.7% 37.0% 37.0% 36.9% 39.4% 41.2% 16.72% 15.65% 15.63% 15.27% 1.21 1.18 1.15 1.20 78.4% 79.5% 78.5% 76.9% 8.22% 7.37% 6.44% 6.23% 1.20% 1.09% 1.18% 1.21%

51.6% 49.7% 46.1% 45.0%

45.0% 46.2% 46.9% 54.0%

34.1% 33.0% 31.9% 31.6%

SurvivorsandOthersbeforeYear3 1490.7 746.6 1141.8 755.8 768.4 48.6% 48.8% 31.3% 31.9%

Table5:ProbitModelsofDelistingandMultinomialProbitModelsofAcquisitionandFailure
Estimatesarebasedon218explorationfirms,including2015firmyearswith117acquiredfirmsand41failedfirms. Observations are coded as delisted, failed, or acquired if the observation year is the last year before delisting. Failed firms include bankrupt, liquidated, and delisted for reasons other than acquisition. Book value models in Panel (a) are based on the Baker and Wurgler (BW) measure. They include book value leverage measured three yearsprior to the observation year,and thechange in book value fromthreeyearsprior until the observation year. Book value models in Panel (b) are based on the Lemmon, Roberts, and Zender (LRZ) measure. Market value models in Panel (c) are based on BW and are structured analogously. Statistical significance is estimated with standard errors clustered by firms. Significance levels in twotailed tests are ***, **, and * for the 0.01, 0.05, and 0.10levels,respectively.

ProbitModels Delisted

MultinomialProbitModels Acquired Failed

Panel(a)BWBookValueModels LnBookLeverage Lag3LnBookLeverage LnAssets Profitability MarkettoBook TangibleAssets CashFlowVolatility Priorto1978

Coef. 0.0398 0.0171 0.0112 0.0191 0.0001 0.0855 0.1070 0.0387

pvalue 0.000 0.076 0.001 0.645 0.992 0.034 0.125 0.012

*** * *** ** **

Coef. 0.0162 0.0171 0.0035 0.0859 0.0006 0.0973 0.0747 0.0349 0.0008 0.0171 0.0162 0.0008 0.0013 0.0046 0.0029 0.0742 0.0007 0.1056 0.0815 0.0334 0.0033 0.0046 0.0013 0.0033 0.0181 0.0133 0.0038 0.0894 0.0052 0.0960 0.0728 0.0358 0.0048 0.0133 0.0181 0.0048

pvalue 0.077 0.042 0.263 0.038 0.937 0.012 0.188 0.001

* ** ** ** ***

Coef. 0.0121 0.0014 0.0043 0.0191 0.0032 0.0016 0.0090 0.0003

pvalue 0.000 0.488 0.002 0.038 0.016 0.842 0.578 0.947

*** *** ** **

LnBookLeverage ChangeinLnBookLeverage

0.0227 0.0171 0.0398 0.0227 0.0073 0.0030 0.0105 0.0050 0.0019 0.0879 0.1413 0.0395

0.020 ** 0.076 * 0.000 *** 0.020 ** 0.264 0.602 0.002 0.907 0.797 0.030 0.053 0.011 *** ** * **

0.926 0.042 **

0.0135 0.0014

0.000 *** 0.488 0.000 *** 0.000 *** 0.060 0.169 0.000 0.026 0.440 0.797 0.940 0.374

ChangeinLnBookLeverage Lag3LnBookLeverage Panel(b)LRZBookValueModels LnBookLeverage Lag3LnBookLeverage LnAssets Profitability MarkettoBook TangibleAssets CashFlowVolatility Priorto1978

0.077 * 0.926 0.814 0.341 0.371 0.074 0.929 0.007 0.147 0.002 ** *** ***

0.0121 0.0135 0.0042 0.0024 0.0059 0.0288 0.0011 0.0024 0.0017 0.0037 0.0066 0.0024

* *** **

LnBookLeverage ChangeinLnBookLeverage

0.0043 0.0030 0.0073 0.0043 0.0388 0.0125 0.0107 0.0219 0.0149 0.0831 0.1145 0.0398

0.499 0.602 0.264 0.499 0.000 0.123 0.001 0.604 0.044 0.036 0.105 0.010 *** *** ** ** ***

0.543 0.341 0.814 0.543 0.039 0.055 0.228 0.036 0.580 0.013 0.202 0.001 ** * ** ** ***

0.002 *** 0.169 0.060 * 0.002 *** 0.000 0.340 0.002 0.040 0.257 0.922 0.748 0.987

ChangeinLnBookLeverage Lag3LnBookLeverage Panel(c)BWMarketValueModels LnMarketLeverage Lag3LnMktLeverage LnAssets Profitability MarkettoBook TangibleAssets CashFlowVolatility Priorto1978

0.0042 0.0066 0.0118 0.0019 0.0041 0.0187 0.0022 0.0007 0.0050 0.0001 0.0137 0.0019

*** *** **

LnMarketLeverage ChangeinLnMktLeverage

0.0263 0.0125 0.0388 0.0263

0.006 *** 0.123 0.000 *** 0.006 ***

0.586 0.055 * 0.039 ** 0.586

0.000 *** 0.339 0.000 *** 0.000 ***

ChangeinLnMarketLeverage Lag3LnMarketLeverage

0.0118 0.0137

Table7:ProbitModelsofDelistingandMultinomialProbitModelsofAcquisitionandFailure
Estimates are based on 218 exploration firms, including 2015 firmyears with 117 acquired firms and 41 failed firms. Observations are codedas delisted, failed, or acquired if the observationyear is the last year beforedelisting. Failed firms include bankrupt, liquidated, and delisted for reasons other than acquisition. Book value models are based on the Baker and Wurgler (BW) measure of leverage. They include book value leverage measured three years prior to theobservationyear,andthechangeinbookvaluefromthreeyearsprioruntiltheobservationyear.Panel(a)shows quadratic specifications of leverage. Panel (b) shows linear spline specifications of high and low leverage. Panel (c) shows linear spline results for bottom and top deciles or quintiles. Statistical significance is estimated with standard errors clustered by firm. Significance levels in twotailed tests are ***, **, and * for the 0.01, 0.05, and 0.10 levels, respectively.
Panel(a)QuadraticModels LnBookLeverage Lag3LnBookLeverage LnBookLeverage^2

ProbitModels Delisted Coef. pvalue 0.0622 0.000 *** 0.0170 0.079 * 0.0104 0.089 * 0.0395 0.0139 0.0011

MultinomialProbitModels Acquired Failed Coef. pvalue Coef. pvalue 0.0058 0.754 0.0192 0.000 *** 0.0170 0.040 ** 0.0014 0.516 0.0094 0.195 0.0041 0.016 **

LnBookLeverage Lag3LnBookLeverage Lag3LnBookLeverage^2

0.000 *** 0.421 0.817

0.0162 0.0169 0.0001 0.0072 0.0134 0.0099 0.0013

0.081 * 0.373 0.991 0.710 0.461 0.189 0.807

0.0121 0.0018 0.0002

0.000 *** 0.525 0.811

LnBookLeverage Lag3LnBookLeverage LnBookLeverage^2 Lag3LnBookLeverage^2 Panel(b)SplineHighLowModels LnBookLeverage LnBookLeverageAboveMean Lag3LnBookLeverage

0.0627 0.000 *** 0.0189 0.305 0.0189 0.087 * 0.0006 0.903 0.0421 0.000 *** 0.0762 0.000 *** 0.0153 0.106

0.0204 0.027 ** 0.0390 0.016 ** 0.0162 0.052 * 0.0165 0.0165 0.0173 0.0205 0.0389 0.0162 0.0008 0.0019 0.0165 0.0233 0.0807 0.0013 0.0166 0.0305 0.0354 0.0182 0.0294 0.0434 0.0301 0.0170 0.0236 0.0277 0.0070

0.0193 0.000 *** 0.0008 0.794 0.0042 0.016 ** 0.0003 0.788 0.0104 0.002 *** 0.0128 0.019 ** 0.0016 0.445

LnBookLeverage Lag3LnBookLeverage Lag3LnBookLeverageAboveMean

0.0401 0.0167 0.0055

0.000 *** 0.080 * 0.766 0.000 0.000 0.100 0.729 0.439 0.099 0.021 0.208 0.859 0.106 0.012 0.339 0.000 0.057 0.154 0.411 0.000 0.316 0.389 0.993 *** *** * * ** **

0.075 * 0.048 ** 0.732

0.0117 0.0016 0.0029

0.000 *** 0.462 0.447

LnBookLeverage 0.0418 LnBookLeverageAboveMean 0.0773 Lag3LnBookLeverage 0.0158 Lag3LnBookLeverageAboveMean 0.0064 Panel(c)SplineModelsofLeverageExtremes LnBookLeverage 0.0118 Lag3LnBookLeverage 0.0158 TopDecileNoLag 0.1225 BottomDecileNoLag 0.0580

0.027 0.016 0.054 0.965 0.883 0.043 0.658 0.055 0.944 0.046 0.532 0.251 0.056 0.036 0.321 0.304 0.070 0.231 0.542 0.800

** ** * ** * * * ** *

0.0097 0.002 *** 0.0134 0.014 ** 0.0019 0.428 0.0051 0.239 0.0126 0.004 *** 0.0016 0.460 0.0107 0.342 0.0193 0.033 **

LnBookLeverage Lag3LnBookLeverage TopQuintileNoLag BottomQuintileNoLag

0.0037 0.0156 0.1301 0.0336 0.0419 0.0298 0.0553 0.0261

0.0111 0.0016 0.0146 0.0129

0.062 0.452 0.235 0.174 0.000 0.303 0.819 0.233

* *** ***

LnBookLeverage Lag3LnBookLeverage TopDecileLag3 BottomDecileLag3

*** * ***

0.0116 0.0030 0.0015 0.0058

LnBookLeverage Lag3LnBookLeverage TopQuintileLag3 BottomQuintileLag3

0.0402 0.0217 0.0363 0.0003

0.0113 0.0057 0.0048 0.0084

0.000 0.221 0.531 0.190

AppendixA:ClassificationCodesUsedinOilIndustrySampleSelection SICandSICH: StandardIndustrialClassification CrudePetroleumandNaturalGas PetroleumRefining

1311 2911 NAICSandNAICSH:

NorthAmericanIndustryClassificationSystem CrudePetroleumandNaturalGasExtraction NaturalGasExtraction PetroleumRefineries PetroleumProductsRetailingandWholesaling CrudeOilMarketingandRefining PetroleumProductsWholesaling

211111 211112 324110 422710 422720 424720 GSUBIND:

GlobalIndustriesClassificationStandard(S&P) IntegratedOilandGas OilandGasExplorationandProduction OilandGasRefiningandMarketing

10102010 10102020 10102030 S&P: 380 382 385 390

S&P(Old)IndustryCodes OilandGasExplorationandProduction OilandGasRefiningandMarketing OilandGasIntegratedRefiningandMarketing OilandGasInternationalIntegrated

AppendixB:DefinitionofVariables Thisappendixprovidesdefinitionsofthevariablesusedforourempiricaltests.Compustatitemsaregivenin parentheses. BWmeasuresofleveragefollowingBakerandWurgler(2002): Bookequity=bookassets(AT)totalliabilities(LT)preferredstock(PSTKL)+deferredtaxesandinvestment taxcredits(TXDITC)+convertibledebt(DCVT).Ifpreferredstock(PSTKL)ismissing,itisreplacedwith preferredstockredemptionvalue(PSTKRV). Bookleverage=(bookassets(AT)bookequity)/bookassets(AT). Marketequity=stockprice(PRCC_F) commonsharesoutstanding(CSHO). Marketleverage=(bookassets(AT)bookequity)/(bookassets(AT)bookequity+marketequity). LRZmeasuresofleveragefollowingLemmon,Roberts,andZender(2008): Bookleverage=(shorttermdebt(DLC)+longtermdebt(DLTT))/bookassets(AT). Marketleverage=(shorttermdebt(DLC)+longtermdebt(DLTT))/(shorttermdebt(DLC)+longtermdebt (DLTT)+stockprice(PRCC_F) commonsharesoutstanding(CSHPRI)). WmeasuresofleveragefollowingWelch(2011): Bookleverage=totalliabilities(LT)/bookassets(AT). Marketleverage=totalliabilities(LT))/(bookassets(AT)bookequity(SEQ)+stockprice(PRCC_F) commonsharesoutstanding(CSHO)). CashFlowVolatility=standarddeviation(operatingincomebeforedepreciation(OIBDP)/bookassets(AT)for recent4years). EBITDA/TotalAssets(Profitability)=operatingincomebeforedepreciation(OIBDP)/bookassets(AT). Markettobook=firmsmarkettobookratio=(stockprice(PRCC_F) commonsharesoutstanding(CSHPRI)) +shorttermdebt(DLC)+longtermdebt(DLTT)+preferredstock(PSTKL)deferredtaxesand investmenttaxcredits(TXDITC))/bookassets(AT). Marketshare=netsales(SALE)/sumofnetsales(SALE)ofsamplefirmsintheexplorationindustry. Priorto1978=dummyvariablewhichissetequaltooneifthefirmyearobservationisbefore1978andzero otherwise. Salesrevenue=netsales(SALE). Size=log(bookassets(AT)). Tangibleassets=property,plant,andequipment(PPENT)/bookassets(AT). TotalDebt=bookassets(AT)bookequity.

AppendixC:ProbitModelsofDelistingandMultinomialProbitModelsofAcquisitionandFailure withtheLRZMeasureofBookLeverage
Estimates are based on 218 exploration firms, including 2015 firmyears with 117 acquired firms and 41 failed firms. Observations are coded as delisted, failed, or acquired if the observation year is the last year before delisting. Failed firms include bankrupt, liquidated, and delisted for reasons other than acquisition. Book value models are based on the Lemmon, Roberts, and Zender (LRZ) measure of leverage. They include book value leverage measured three years prior to the observation year, and the change in book value from three years prior until the observation year. Panel (a) shows quadratic specifications of leverage. Panel (b) shows linear splinespecificationsofhighandlowleverage.Panel(c)showslinearsplineresultsforbottomandtopdecilesor quintiles. Statistical significance is estimated with standard errors clustered by firm. Significance levels in two tailedtestsare***,**,and*forthe0.01,0.05,and0.10levels,respectively.
Panel(a)ModelswithSquaredTerms LnBookLeverage Lag3LnBookLeverage LnBookLeverage^2

ProbitModels Delisted Coef. pvalue 0.0492 0.012 ** 0.0043 0.463 0.0088 0.025 **

MultinomialProbitModels Acquired Failed Coef. pvalue 0.0098 0.555 0.0048 0.322 0.0017 0.612

Coef. pvalue 0.0185 0.000 *** 0.0015 0.268 0.0033 0.001 **

LnBookLeverage Lag3LnBookLeverage Lag3LnBookLeverage^2

0.0071 0.0135 0.0034

0.278 0.444 0.332

0.0011 0.0029 0.0015

0.837 0.868 0.654

0.0042 0.0069 0.0010

0.052 * 0.100 * 0.215

LnBookLeverage Lag3LnBookLeverage LnBookLeverage^2 Lag3LnBookLeverage^2

0.0472 0.0025 0.0084 0.0014

0.022 0.896 0.042 0.714

** **

0.0078 0.0011 0.0013 0.0012

0.653 0.954 0.706 0.738

0.0180 0.0032 0.0032 0.0004

0.000 0.378 0.002 0.616

*** ***

Panel(b)SplineHighLowModels LnBookLeverage LnBookLeverageAboveMean Lag3LnBookLeverage

0.0058 0.437 0.0766 0.002 0.0044 0.760

***

0.0015 0.825 0.0201 0.358 0.0049 0.310

0.0018 0.0232 0.0014

0.302 0.000 *** 0.265

LnBookLeverage Lag3LnBookLeverage Lag3LnBookLeverageAboveMean

0.0071 0.0083 0.0325

0.277 0.220 0.143

0.0009 0.0087 0.0270

0.872 0.120 0.178

0.0043 0.0015 0.0040

0.054 * 0.485 0.491

LnBookLeverage LnBookLeverageAboveMean Lag3LnBookLeverage Lag3LnBookLeverageAboveMean

0.0052 0.0724 0.0067 0.0151

0.493 0.005 0.327 0.521 0.973 0.600 0.002 0.948

*** ***

0.0006 0.0120 0.0084 0.0241

0.931 0.596 0.140 0.250

0.0018 0.0233 0.0015 0.0002

0.312 0.000 0.376 0.960

*** ***

Panel(c)SplineModelsofLeverageExtremes LnBookLeverage 0.0003 Lag3LnBookLeverage 0.0031 TopDecileNoLag 0.1709 BottomDecileNoLag 0.0011

0.0023 0.0043 0.0444 0.0070

0.252 0.230 0.005 0.242

0.778 0.376 0.447 0.655

0.0027 0.0018 0.0367 0.0037 0.0012 0.0016 0.0318 0.0019

LnBookLeverage Lag3LnBookLeverage TopQuintileNoLag BottomQuintileNoLag

0.0065 0.0033 0.1494 0.0055

0.617 0.566 0.000 0.736 0.279 0.854 0.190 0.496

***

0.0052 0.0044 0.0496 0.0064

0.652 0.361 0.230 0.654 0.869 0.722 0.271 0.432

0.678 0.244 0.002 0.547 0.059 0.282 0.691 0.929

***

LnBookLeverage Lag3LnBookLeverage TopDecileLag3 BottomDecileLag3

0.0071 0.0014 0.0428 0.0125 0.0071 0.0003 0.0426 0.0098

0.0009 0.0024 0.0355 0.0126

0.0043 0.0023 0.0031 0.0003 0.0043 0.0028 0.0045 0.0017

LnBookLeverage Lag3LnBookLeverage TopQuintileLag3 BottomQuintileLag3

0.281 0.980 0.171 0.528

0.0009 0.0014 0.0329 0.0079

0.874 0.897 0.273 0.574

0.055 0.290 0.519 0.519