Tuesday, August 17, 2004

Leary and Roberts answer "Do Firms Rebalance Their Capital Structures?"

Mark Leary and Michael Roberts answer the question: Do Firms rebalance their capital structures?
And their answer? Yes!

Short Version:
Leary and Roberts find that once adjustment costs are considered, firms do in fact try to return their capital structure towards some long run average or optimal level. This is contrary to previous literature on the topic,
Longer Version:

Longer Version:
In virtually all corporate finance classes there is a discussion of capital structure (how much debt a firm uses). Once Modigliani and Miller’s assumptions are relaxed, we generally conclude that there is some “optimal level” of debt, or minimally an “optimal range.” This range is determined by the type of assets (if the asset can be used as collateral it supports more debt), the type of business (risky businesses support less debt), growth options (more options, less debt), and other factors.

Empirically this is supported when we look at industries where by and large there is similarity between the debt levels of the firms. However, the support is far from perfect and the exceptions and deviations from what long run averages (that could somehow be seen as optimal) have led many researchers to examine whether firms do try to keep their debt ratios at some “target ratio.”

Many of these authors have found that the deviations from the target seem to be larger and to exist for longer periods, than would be expected. For example
Leary and Roberts write:

“Fama and French (2002) note that firms' debt ratios adjust slowly towards their targets. That is, firms appear to take a long time to return their leverage to its long-run mean or, loosely speaking, optimal level. Baker and Wurgler (2002) document that historical efforts to time equity issuances with high market valuations have a persistent impact on corporate capital structures. This fact leads them to conclude that capital structures are the cumulative outcome of historical market timing efforts, rather than the result of a dynamic optimizing strategy. Finally, Welch (2004) finds that equity price shocks have a long-lasting effect on corporate capital structures as well. He concludes that stock returns are the primary determinant of capital structure changes and corporate motives for net issuing activity are largely a mystery.”

[A problem with] “Most empirical tests, however, [is that they] implicitly assume that this rebalancing is costless. In the absence of adjustment costs, firms can continuously rebalance their capital structures towards an optimal level of leverage. However, in the presence of such costs, it may be suboptimal to respond immediately to capital structure shocks.”

In the current paper Leary and Roberts set out to correct for this problem by considering adjustment costs. When they do so, they find that firms do, albeit sometimes slowly, adjust their capital structures.

In their words: “the effect of equity issuances on firms' leverage is erased within two years by debt issuances. Similarly, the effect of large positive (negative) equity shocks on leverage is erased within the two to four years subsequent to the shock by debt issuances (retirements).”

“Further, when firms do decide to visit the capital markets they tend to do so in several closely spaced, often consecutive, quarters. This temporal pattern
in financing decisions is consistent with the recent empirical evidence of Altinkilic and Hansen (2000), who show that debt and equity issuance costs consist of both a fixed cost and a convex variable cost.”

The paper goes on to explain why these findings are consistent with both the pecking order and the tradeoff model. And to show that the findings are also in line with survey literature that shows executives do have a target capital structure in mind.

Overall a very good and important article!


Leary , Mark and Roberts, Michael R., "Do Firms Rebalance Their Capital Structures?" (June 7, 2004). 14th Annual Utah Winter Finance Conference; Tuck Contemporary Corporate Finance Issues III Conference Paper. http://ssrn.com/abstract=571002

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