Testing Trade-Off Theory After U.S. Housing Bubble in 2008

Abstract

In this paper, we study the relationship between firm value and debt level. As all firms try to increase the wealth of shareholders, managements like to increase stock price by adjusting their debt levels, if the debt level influences on firm value. Some theories such as MM’s irrelevant theory and the pecking order theory suggest no optimal capital structure. However, the traditional tread-off theory and MM’s 1963 theory show the existence of the optimal debt level. If firms try to maximise their values and if debt level influences on firm value, firms try to adjust their debt levels to increase value, though we do not sure exactly where the optimal capital structure is for a firm. Furthermore, we also do not sure which theory is better than others to explain firm’ financing policies; and different theory suggests different methods to reach optimal capital structure. In general, without considering any specific capital structure theory, firms try to use tax benefits or reduce their costs caused by using debt; while doing so, firms close to reach their optimal capital structure. We call this idea as a wider trade-off theory. In addition, we also presume that firms’ financial polices are acts of adapting financial market condition. Under certain circumstance, increasing or decreasing debt level brings benefit for firms if firms act in right way in accordance with financial market and economic conditions. For example, during the recession, reducing debt level is probable better for firms and vice versa. We use Tobin’s Q, PER and PBR for the proxies of firm value. First, we have compared the level of these proxies with firms’ debt level in line with different industries; and we find that Tobin’s Q and debt level have a negative association in most of our sample industries but from the results using PER and PBR we cannot find a clear relationship between them. In addition, using a liner regression estimator, we try to find a clearer relation between them; and we find a negative association between firm value and debt level with all three different firm value proxies. This result of course supports the pecking order theory. In addition, in order to test the trade-off theory, we use a quadric equation model; and our quadric equation model does not support the trade-off theory. In this paper, we use data that was collected after the U.S. financial crisis in 2008, as we worry about the influence of the world financial crisis on our sample data. It is possible that our results may be caused by data period, as most firms more likely conceives economic depression. After the U.S. housing bubble, many countries faced serious financial problems. It might be better for Korean firms to reduce debt levels for uncertain future economic environment too. This fact implies the reason why our results present the negative association between firm value and debt level. However, we may understand that under the trade-off theory firms try to reduce their debt levels to adapt new economic circumstance which is financially unstable.