Revealed Preferences for Corporate Leverage

Abstract

I consider a simple model of dynamic capital structure with adjustment costs, and I show how financial decisions reveal firms’ preferences for leverage. I show that the most commonly used empirical models of capital structure (the partial adjustment model, e.g. Fama and French (2000) and the financial deficit model, e.g. Shyam-Sunder and Myers (1999)) are mis-specified. Estimating a correctly specified model yields new insights and solves spurious puzzles: The expected future financial deficit is a significant determinant of the current choice of debt versus equity, and profitable firms have a higher target leverage. However, while the value functions that I estimate display qualitatively sensible properties, they also appear extremely flat for moderate values of leverage, which is inconsistent with tax-based theories. The methodology that I propose can be readily extended to test the importance of other determinants of capital structure decisions. As an application, I show that CEO tenure flattens the left part of the estimated value function, which is consistent with agency theories. Corporate finance textbooks summarize the static trade-off model of capital structure with a simple picture of the value of the firm as a function of its leverage, as shown on Figure 1. In fact, other theories can be represented by an objective function, together with a pair of adjustment cost functions for debt and equity. In the cumulative pecking order theory, the objective function is flat and the adjustment costs are much higher for equity issues than for debt issues. The agency view is that the objective function represents managerial preferences, as opposed to the value of the firm for its claim holders. My contribution in this paper is to estimate the objective function revealed by actual firms’ decisions. I use the simplest theoretical framework to derive an empirically estimable equation. Despite its simplicity, this equation offers new insight into capital structure dynamics: As predicted by the theory, the expected future financial deficit is a significant determinant of current decisions to issue debt or equity. I also find that profitable firms have a higher target leverage ratio, and that adjustment costs for debt are smaller than for equity. However, while the objective functions that I estimate display qualitatively sensible properties, they also appear extremely flat for moderate values of leverage, which is inconsistent with tax-based theories. The methodology that I propose can be readily extended to test the importance