Actual Debt Ratios Research Articles

The dynamic trade-off theory of capital structure: evidence from a panel of US industrial companies

PurposeThis paper aims to test the empirical validity of the dynamic trade-off theory in its symmetric and asymmetric versions in explaining the capital structure of a panel of publicly listed US industrial firms over the period from 2013 to 2019. It analyzes the existence of an adjustment of leverage toward its target level and whether the speed of this adjustment is influenced by the debt measure, the model specification or/and the fact that the actual debt ratio is higher or lower than its long-term target level.Design/methodology/approachThis paper uses a quantitative research methodology using panel data analysis under the partial adjustment model and the error correction model using the generalized moment method in first differences and in systems to explore the dynamic nature of firms’ capital structure behavior.FindingsThe results show that the effects of the conventional determinants of leverage are globally consistent with the trade-off theory predictions. The dynamic versions confirm that firms exhibit leverage-targeting behavior. Although this speed of adjustment (SOA) depends on the debt and model specifications, it is around 60% on average. The estimated SOA is higher for the market leverage measure compared to the book leverage. The asymmetric adjustment model reveals that firms are more sensitive to reducing leverage than increasing it when they are away from their target; overleveraged firms exhibit approximately 5% faster adjustment than underleveraged firms when book leverage is used.Originality/valueThe originality of this research paper lies in its development and test of an asymmetric model to allow the leverage adjustment speed to vary depending on whether the firm’s debt ratio is above or below its target level and the methodological approach as well as the different model specifications used and the insights generated through the application of rigorous econometric techniques.

Determining the Optimal Capital Structure of Coal Company

This study examines stock price decline and coal price uncertainty as business issues. PT Delta Dunia Makmur Tbk has high debtto-equity ratio. High dividend-equity companies pay more interest. Interest costs reduce a company’s net profits and cash available for investment or shareholder payout. This may affect shareholder income and corporate growth. To raise net income and firm value for investors and rebuild trust, PT Delta Dunia Makmur Tbk management must estimate a favorable cost of debt and equity. This study employed secondary data. This study uses 2018-2019 DOID financial statements as secondary data. The lowest WACC helps PT. Delta Dunia Makmur Tbk choose the best capital structure. Calculate capital structure debt and equity costs using the debt-toequity ratio. The Damodaran synthetic rating table calculates loan cost using the interest coverage ratio and PT. Dunia Makmur Tbk default spread value. The actual debt ratio is 83.69%, while the optimal debt ratio is 34%. According to Damodaran, the corporation is overlevered since actual optimal (83.69% > 34%). Delta Dunia is currently in the “GREY ZONE” of the Altman Z-score calculation, hence it is not at risk of bankruptcy. Therefore, the corporation can finance new projects with retained earnings or equity, pay off debt with retained earnings, reduce dividends, issue new shares, or pay off debt. From PT Delta Dunia Makmur Tbk’s financial statements, the debt ratio is 83.69%, the equity ratio is 16.69% with a cost of equity of 19.75%, the WACC generated is 11.02%, and the firm’s value is $965,639,737.72. After simulation, the optimal capital structure for PT Delta Dunia Makmur Tbk was 34% debt, 66% equity, 10.39% cost of equity, and $1,166,687,666.77. According to the Altman Z-score calculation, PT Delta Dunia Makmur Tbk is in the GREY ZONE and not at risk of bankruptcy, so the best way to change the debt ratio is gradually so the company can fund good projects or pay debt with new equity and retained earnings.

Shareholder personal risk and firm risk: An empirical analysis of share pledges and firm debt policies.

The impact of personal risk caused by controlling shareholders' equity pledges on the company's debt policy is an issue worth exploring. Using Chinese A-share listed companies from 2006 to 2020, this paper studies the impact of ultimate owner equity pledges on firm debt size and debt maturity structure and explores the mechanism of ultimate owner personal leverage on firms. The results show that the increase in ultimate owner stock pledges leads to higher financial leverage and a longer debt maturity structure for the company. In addition, the study reveals that the high personal leverage of the ultimate owner of the pledged equity is an influential mechanism driving the transfer of personal risk to the firm. In particular, even if a company's actual debt ratio is higher than its target debt ratio, equity pledges can prompt listed companies to increase their debt ratios and debt maturities, causing them to take on excessive debt risk and transfer the risk to creditors. It follows that the tunneling effect is a driving force of equity pledging and corporate debt policies. These results remain robust after the robustness test and endogenous test. The conclusions of this paper not only emphasize the impact of shareholders' personal risk on the firm but also provide a reference for investors' perception of firm risk.

Corporate leverage and monetary policy transmission mechanism in India: A dynamic approach.

The macroeconomic policies of a nation have a major bearing on the financial performance of the companies and their potential sustainability and growth. This study investigates the impact of monetary policy on the corporate leverage adjustment through microscopic monetary policy transmission channels, mainly the interest rate and credit channels, using a sample of 422 manufacturing firms in India from 2011 to 2017 by employing partial adjustment model. The findings suggest that contractionary monetary policy cuts down overall corporate debt. The study further asserts that corporate debt in Indian firms demonstrates target behaviour and the speed at which firms adjust their actual debt ratios towards target debt ratios is a function of not only firm-specific characteristics but also macroeconomic conditions prevailing in the country, proxied by monetary policy indicators in our study. The study has critical policy implications as the balance sheet situation of corporates is a crucial factor in the financial stability of the economy.

Testing trade-off theory and pecking order theory under managerial overconfidence

Abstract We address our research to the problem of managerial overconfidence and financing behavior. The aim of the paper is, hence, to ascertain the pattern of financing decisions of overconfident managers and identify the relevant capital structure theory (trade-off or pecking order theory) that can be used to explain financing decisions of overconfident managers. We collected a sample of 145 private companies. The degree of overconfidence was distinguished by surveying the managers on overestimation, overplacement, and overoptimism. The financial data covers the period of 2010–2015. We calculated static ratios of capital structure and uncovered the determinants of capital structure. We then unveiled the target debt ratios using Fama and French methodology and identified the difference between target and actual debt ratios. We also calculated the value of deficit and the sources of financing according to Shyam-Sunder and Myers. We found that the companies managed by overconfident managers use higher value of equity and display similar debt ratios. They also utilize reverse pecking order preference—trying to use internal funds and then turning to equity. Moreover, we noted that companies managed by overconfident managers come closer to target debt ratios and implement more risky fixed assets financing strategies. The significance of our research is that we contribute to the understanding of capital structure decisions by taking into account behavioral biases and conducting comprehensive research on both static and dynamic capital structure.

Lending in the Nonfinancial Sector

The article analyzes borrowing by the nonfinancial sector of the Russian economy. The relevance of this topic is related to a decrease in credit availability, the high credit risk of a number of industries, and the importance of lending for a successful use of the present window of opportunity. Our comprehensive analysis of lending to the nonfinancial sector is based on the statistical reports of enterprises and credit institutions, and on the evaluations of the Bank of Russia. The article highlights the performance dynamics of enterprises in the nonfinancial sector and their current reliance on the Russian banking system, identifies the dynamics and actual debt ratios of the nonfinancial sector and the role of domestic banks in their borrowing, and discusses the imbalances and risks associated with increased lending by Russian banks.

Taxation and the optimal constraint on corporate debt finance: why a comprehensive business income tax is suboptimal

The tax bias in favour of debt finance under the corporate income tax means that corporate debt ratios exceed the socially optimal level. This creates a rationale for a general thin capitalization rule limiting the amount of debt that qualifies for interest deductibility. This paper sets up a model of corporate finance and investment in a small open economy to identify the optimal constraint on tax-favoured debt finance, assuming that a given amount of revenue has to be raised from the corporate income tax. For plausible parameter values, the socially optimal debt-asset ratio is 2–3% points below the average corporate debt level currently observed. Driving the actual debt ratio down to this level through limitations on interest deductibility would generate a total welfare gain of about 5% of corporate tax revenue. The welfare gain would arise mainly from a fall in the social risks associated with corporate investment, but also from the cut in the corporate tax rate made possible by a broader corporate tax base.

Information in the Tax Benefit Curves of Selected Nigerian Quoted Firms

Following Graham (2000), this study evaluates the role of tax benefit curves in defining the risk appetite of selected Nigerian quoted firms in the setting of corporate debt policy. The non-financial corporations quoted on the Nigerian Stock Exchange (NSE) for the period 1999-2014 constitute the population of study. Out of these, 50 companies that met the minimum data criteria were selected as sample. Using a combination of the panel data least squares regression, Modigliani-Miller tax benefit formula, the Miller equilibrium and the Graham simulation technique, the research documents the following findings. First, firm-specific characteristics such as profitability, liquidity, size, market-to-book ratio and asset tangibility exert downward pressure on corporate borrowing consistent with pecking order arguments. In other words, asymmetric information rationalizes the aggressive debt posture of smaller, less profitable, less liquid firms with more risky intangible assets and low dividend-payers. The Kink and ZeroBenefit statistics are consistent with actual debt ratios being less than the trade-off model’s predictions. The study recommends the use of non-debt tax shelters for corporate tax planning, government simplification of tax administration.

Taxation and the Optimal Constraint on Corporate Debt Finance

The tax bias in favour of debt finance under the corporate income tax means that corporate debt ratios exceed the socially optimal level. This creates a rationale for thin-capitalization rules limiting the amount of debt that qualifies for interest deductibility. This paper sets up a model of corporate finance and investment in a small open economy to quantify the deadweight loss from the asymmetric tax treatment of debt and equity and to identify the second-best optimal debt-asset ratio in the corporate sector. For plausible parameter values derived from data for the Norwegian economy, the deadweight loss from the tax distortions to corporate financing decisions amounts to 2-3 percent of total corporate tax revenue, and the socially optimal debt-asset ratio is 4-5 percentage points below the debt level currently observed. Driving the actual debt ratio down to this level would generate a total welfare gain of about 3 percent of corporate tax revenue. The welfare gain would arise partly from a fall in the social risks associated with corporate investment, and partly from the cut in the corporate tax rate made possible by a broader corporate tax base.

Mergers, Debt Capacity, And Stockholder-Bondholder Wealth Transfers

This study presents a framework for determining whether post merger actual debt of a merged firm is higher than its potential debt capacity. Our results show that on the average, actual debt of the merged firm is significantly higher than its potential debt capacity, and that the proportion of firms with actual debt higher than potential debt capacity is higher than expected. This evidence is consistent with the argument that the co-insurance wealth transfer from shareholders to bondholders is negated by increased leverage post merger. The results on abnormal returns to bondholders for the two subgroups with actual debt higher/lower than the potential debt capacity support the neutralization of wealth transfers. Forty-nine industrial mergers during 1970-1984 and the associated debentures comprise the sample. We measure the potential debt capacity after the merger based on a theoretical model using pre-merger correlation of the cash flows of the merging firms and their debt ratios. Our results indicate that post merger actual debt ratios are significantly higher than the potential theoretical ratios providing support for the increased debt capacity as motive for merger. We also find evidence for leverage induced neutralization of wealth transfers to bondholders.

Financial liberalization and firms’ capital structure adjustments evidence from Southeast Asia and South America

This paper investigates the impact of financial liberalization on the adjustment of debt ratios in 12 emerging markets using firm-level data from 1991 to 2004. The results support the central hypothesis of this paper that adjustment costs are important in explaining firms’ adjustment toward their debt ratio targets. Our results show that deviations from targets are halved within 1.09 years in South America and 1.19 years in Southeast Asia, suggesting speed of adjustment is relatively faster in South American countries than Southeast Asian countries. Furthermore, our results show that after full liberalization those countries where rule of law and creditors rights were properly enforced, firms had higher adjustment speed compared to those countries where such enforcement was not present. The estimated adjustment coefficients imply that on average firms’ adjustment speeds have increased in all South American countries over the period of financial liberalization. On the contrary, firms’ adjustment speeds did not increase in Southeast Asian countries, reflecting the uneven effect of liberalization on the firms’ financing behaviour in Asian countries. There was a significant reduction in time (in years) taken to half the gap between actual debt ratios and targets only in Pakistan and South Korea. This finding supports the idea of uncertain impact of financial liberalization programs on the domestic financial markets in those emerging markets which started opening up their market and integrating with the rest of the world latter than others. These findings have significant implications for the sequence of banking sector liberalization in the emerging markets.

A Radical (Yet Simple!) Explication of the Capital Structure Puzzle

Invoking them without modeling them is a cop-out (Myers 1984, p. 578). Myers is here referring to the theory that large capital adjustment costs might explain the observed wide variation in actual debt ratios. We can similarly criticize the static trade-off theory of capital structure as typically presented in the form of simple line drawings, with no supporting numerical model. This paper contends that conventional expositions of the static trade-off theory overstate both the debt tax shield erosion and value-adding consequences of borrowing within a classical tax system. it demonstrates the construction of a simple numerical model of the static trade-off theory, which shows how small changes to the values of input variables can shift optimal firm value over a wide range of debt ratios.

Avoiding Distortion in Corporate Valuation Litigation: An Application of Discounted Cash Flow

Avoiding Distortion in Corporate Valuation Litigation: An Application of Discounted Cash Flow

A Dynamic Model of Optimal Capital Structure

This paper presents a continuous time model of a firm that can dynamically adjust both its capital structure and its investment choices. In the model we endogenize the investment choice as well as firm value, which are both determined by an exogenous price process that describes the firm's product market. Within the context of this model we explore cross-sectional as well as time-series variation in debt ratios. We pay particular attention to interactions between financial distress costs and debtholder/equityholder agency problems and examine how the ability to dynamically adjust the debt ratio affects the deviation of actual debt ratios from their targets. Regressions estimated on simulated data generated by our model are roughly consistent with actual regressions estimated in the empirical literature. Copyright 2007, Oxford University Press.

Target Behavior and Financing: How Conclusive is the Evidence?

The notion that firms have debt ratio targets and that this is a primary determinant of financing behavior is influential in finance. Yet, how definitive is the available evidence? We examine this question by benchmarking the dynamics of actual debt ratios and the pattern of financing after major leverage-changing events against what is observed when samples are generated through simulations in which no target behavior is assumed. We find that the collective evidence that has been interpreted as indicative of target behavior is much weaker than is generally recognized. Specifically, the simulated data show similar reversal of the debt ratio and patterns of debt and equity issuance after major issuance activities or shocks to stock returns as in the actual data. We attribute the former to a mechanical reversal that exists on average, even with random financing, if the debt ratios are above or below a cut-off, and the latter to persistence of the financing deficit around major issuance activities. Some of the evidence in the actual data, however, can only be replicated if the simulation samples are modified to accommodate a specific type of market timing behavior. emmon, Roberts, and Zender (2006) find that differences in initial leverage ratios persist over time; remarkably, the simulated data exhibits similar persistence. Our results show that a firm-specific component in the time-series of the financing deficit and change in retained earnings contributes to this persistence. On the whole, however, our results indicate that there is not much to be learnt from the behavior of the debt ratios as to firms' motives for different types of financing.

United States current account deficits: A stochastic optimal control analysis

The “Pessimists” and the “Optimists” disagree whether the US external deficits and the associated buildup of US net foreign liabilities are problems that require urgent attention. A warning signal should be that the debt ratio deviates significantly from the optimal ratio. The optimal debt ratio or debt burden should take into account the vulnerability of consumption to shocks from the productivity of capital, the interest rate and exchange rate. The optimal debt ratio is derived from inter-temporal optimization using Dynamic Programming, because the shocks are unpredictable, and it is essential to have a feedback control mechanism. The optimal ratio depends upon the risk adjusted net return and risk aversion both at home and abroad. On the basis of alternative estimates, we conclude that the Pessimists’ fears are justified on the basis of trends. The trend of the actual debt ratio is higher than that of the optimal ratio. The Optimists are correct that the current debt ratio is not a menace, because the current level of the debt ratio is not above the corresponding level of the optimum ratio.

United States Current Account Deficits: A Stochastic Optimal Control Analysis

The Pessimists and the disagree whether the US external deficits and the associated buildup of US net foreign liabilities are problems that require urgent attention. A warning signal should be that the debt ratio deviates significantly from the optimal ratio. The optimal debt ratio or debt burden should take into account the vulnerability of consumption to shocks from the productivity of capital, the interest rate and exchange rate. The optimal debt ratio is derived from inter-temporal optimization using Dynamic Programming, because the shocks are unpredictable, and it is essential to have a feedback control mechanism. The optimal ratio depends upon the risk adjusted net return and risk aversion both at home and abroad. On the basis of alternative estimates, we conclude that the Pessimists' fears are justified on the basis of trends. The trend of the actual debt ratio is higher than that of the optimal ratio. The Optimists are correct that the current debt ratio is not a menace, because the current level of the debt ratio is not above the corresponding level of the optimum ratio.

THE CAPITAL STRUCTURE CHOICE: NEW EVIDENCE FOR A DYNAMIC TRADEOFF MODEL

Most academic insights about corporate capital structure decisions come from models that focus on the trade‐off between the tax benefits and financial distress costs of debt financing. But empirical tests of corporate capital structure indicate that actual debt ratios are considerably different from those predicted by the models, casting doubt on whether most companies have leverage targets at all. In particular, there is considerable evidence that corporate leverage ratios reflect in large part the tendency of profitable companies to use their excess cash flow to pay down debt, while unprofitable companies build up higher leverage ratios. Such behavior is consistent with a competing theory of capital structure known as the “pecking order” model, in which management's main objectives are to preserve financing flexibility and avoid issuing equity.The results of the authors' recent study suggest that although past profits are an important predictor of observed debt ratios at any given time, companies nevertheless often make financing and stock repurchase decisions designed to offset the effects of past profitability and move their debt ratios toward their target capital structures. This evidence provides support for a compromise theory called the dynamic tradeoff model, which says that although companies often deviate from their leverage targets, over the longer run they take measures to close the gap between their actual and targeted leverage ratios.