The Effect of Financial Deficit and Target Leverage on Capital Structure and Debt Characteristics: Evidence from First-time Debt Issuers

Abstract

I investigate the motives for issuance and the debt choices of 427 firms which issue long-term debt for the first time in their history between 1971 and 1999. Their first debt issues are very large relative to firm size and represent a permanent shift in firm financing policy. The amount issued is strongly related to deficits in internally generated funds needed to finance investments and only weakly related to deviations from target leverage structure. In the three (or five) years following the initial issuance, the firms remain significantly underlevered, and their deviations from target leverage are only weakly related to subsequent issues of debt and equity. However, firms finance their external deficits with large amounts of external equity as well - while internal cash flows provide 80% of the their funds and subsequent debt issues track deficits more closely than equity issues, equity issues fund approximately 40% of the initial and subsequent deficits. Financial deficits also affect strongly the likelihood of issuance of debt and equity together. I also examine the source and maturity of new debt. Consistent with Diamond's (1991) life-cycle hypothesis, initial debt issues have relatively short maturity and are overwhelmingly not rated, with the number of rated issues increasing afterwards. Firms with large financial needs are more likely to issue rated debt and longer maturity debt, controlling for other determinants of those choices. Overall, financial deficits appear to be an important determinant of the decision to issue debt and of the choice of its characteristics.