Debt-equity Choice Research Articles

Debt-equity choices, R&D investment and market timing

In this paper, we examine whether managers time their debt-equity choices to exploit market mispricing. Controlling for the level of external financing and corporate investment activities, we find evidence consistent with the market timing hypothesis. We find managers issue more equity relative to debt when analysts are relatively optimistic about firms’ long-term growth prospects. Moreover, equity issuers earn lower returns than debt issuers at subsequent earnings announcements. Controlling for research and development (R&D) investment, we find that, consistent with the market timing hypothesis and inconsistent with the extant empirical literature, the debt-equity composition of external financing predicts year-ahead stock return.

The link between capital structure and banking sector performance in an emerging economy

South African banks are small compared to the international standards and this necessitates them to remain efficient and competitive at both national and international levels. Such competitiveness shelter them from global competitors wishing to enter into the South African market. Putting in mind the critical role played by banks in the economic development of every country, managers in the banking industry should ensure they make sound financial decisions in order to remain profitable and competitive amidst challenges of the debt-equity choice. This study seeks to determine the influence of capital structure on profitability of banks listed at the Johannesburg stock exchange (JSE) using the random effect regression model. Empirical studies that studies the impact of capital structure on profitability of the banking sector in emerging markets and Africa are very scant. The few empirical studies that focused on the banking sector are yet to focus on African and to agree on the relationship between capital structure and profitability. It is against these reasons that the current study chose to investigate how profitability of South African banks is affected by their capital structure. The study found out that capital structure is a key determinant of profitability of banks in South Africa. As such, the study recommends that optimal capital policies need to be pursued if banks are to not only to increase profitability but ensure long term stability and sound performance.

Determinants of Debt-Equity Choice – Evidence from Poland

The question of debt-equity choice has so far been widely discussed in literature. The aim of the paper is to analyse the determinants of capital structure of Polish enterprises. We analysed factors that may impact the indebtedness. This analysis fills in the gap in worldwide studies with the case of a country representing the group of „emerging markets”. The paper examines capital structure determinants of non-financial companies listed on the Warsaw Stock Exchange. We used five independent variables compatible with the up-to-date achievements in the field. The results indicate that there is an evidence of a significant negative relationship between the size of a company, its growth rate, profitability, tangibility and the level of total debt. The study shows positive relationship between growth prospects of the company and the debt level. The results of the study indicate that the pecking order theory better explains the changes in indebtedness of analysed companies than other capital structure theories. Obtained results are mostly consistent with earlier studies conducted in the Poland and with studies in Western economies.

The impact of assets-in-place on corporate financing and investment decisions

In a dynamic setting with asymmetric information we consider firms’ debt-equity choice and investment timing. We extend recent research by adding an abandonment option and assets-in-place and we show that these extensions make debt more attractive. This implies, e.g., that mature firms (with larger assets-in-place) mainly use debt financing, whereas young high-growth firms (without assets-in-place) frequently use equity financing and signal their type by early investment. Simulation analyses confirm this and our model is thus able to explain empirical patterns which contradict the static pecking order theory.

Debt-equity decision-making with wealth transfers

Purpose – The purpose of this paper is to instruct advanced business students on the debt-equity choice by showing how wealth transfers between security holders influence security values when a levered firm undergoes an incremental debt-to-equity approach. Design/methodology/approach – The design involves a pedagogical exercise that applies gain to leverage (GL) formulas for a firm aspiring to increase its value by exchanging debt for equity. The valuation method includes perpetuity formulations including those with growth and wealth transfers. The instructional approach offers an understanding of the debt-equity decision. Findings – Unlike studies that provide empirical findings or new theories, this paper provides knowledge and skills for students learning capital structure decision making. Research limitations/implications – All GL equations in this paper are limited by derivational assumptions and estimation of values for variables. Practical implications – This paper bridges the gap between theory and practice by illustrating the impact of the costs of borrowings, growth rates and risk shifts on debt-equity decision making. Students will learn and apply GL equations. They will get an appreciation for the practical complexities of financial decision making including the agency complication embodied in wealth transfers. Social implications – Society can be enhanced to the extent this paper helps future financial managers make optimal capital structure decisions. Originality/value – This paper adds to the Capital Structure Model (CSM) pedagogical research by using the new CSM equations that address a levered situation and incremental approach. As such, it is the first CMS instructional paper to incorporate wealth transfers between security holders.

The financing behaviour of firms and financial crisis

Purpose – The purpose of this paper is to contribute to the capital structure literature by examining the determinants of capital structure from the context of South Africa and to provide evidence of the effects of the 2007/2008 global financial crisis on firm-level determinants of debt-equity choice. Design/methodology/approach – This paper begins by embarking on an extensive review of literature on extant empirical research on capital structure. The panel econometric technique is further adopted to examine firm-level determinants of capital structure and also the impact of 2007/2008 financial crisis. Findings – The findings of the paper suggest that theories of capital structure underpinning debt-equity choice of firms in developed economies are also applicable in the South African context. The authors also find a strong evidence of the effects of the financial crisis on the capital structure of firms in South Africa. Practical implications – This paper serves as springboard on which further research can be grounded and also highlights the interaction between the South African economy and the global economy. Originality/value – The paper provides a fresh evidence on the determinants of capital structure from the Sub-Saharan African context and to the authors’ knowledge, this is the first paper that examines the effects of the 2007/2008 financial crisis on capital structure of firms in South Africa.

Debt-Equity Choices, Growth Options and Market Timing

In this paper, we examine whether managers time their debt-equity choices to exploit market mispricing. Controlling for the level of external financing and corporate investment activities, we find evidence consistent with the market timing hypothesis. We find managers issue more equity relative to debt when analysts are relatively optimistic about firms’ long-term growth prospects. Moreover, equity issuers earn lower returns than debt issuers at subsequent earnings announcements. Controlling for R&D investment, we find that, consistent with the market timing hypothesis and inconsistent with the extant empirical literature, the debt-equity composition of external financing predicts year-ahead stock return.

Firm external financing decisions: explaining the role of risks

Purpose – The main purpose of this paper is to empirically examine how firm-specific (idiosyncratic) and macroeconomic risks affect the external financing decisions of UK manufacturing firms. The paper also explores the effect of both types of risk on firms' debt versus equity choices. Design/methodology/approach – The paper uses a firm-level panel data covering the period 1981-2009 drawn from the Datastream. Multinomial logit and probit models are estimated to quantify the impact of risks on the likelihood of firms' decisions to issue and retire external capital and debt versus equity choices, respectively. Findings – The results suggest that firms considerably take into account both firm-specific and economic risk when making external financing decisions and debt-equity choices. Specifically, the results from multinomial logit regressions indicate that firms are more (less) likely to do external financing when firm-specific (macroeconomic) risk is high. The results of probit model reveal that the propensity to debt versus equity issues substantially declines in uncertain times. However, firms are more likely to pay back their outstanding debt rather than to repurchase existing equity when they face either type of risk. Of the two types of risk, firm-specific risk appears to be more important economically for firms' external financing decisions. Practical implications – The findings of the paper are equally useful for corporate firms in making value-maximizing financing decisions and authorities in designing effective fiscal and monetary policies to stabilize macroeconomic conditions. Specifically, the findings emphasize on the stability of the overall macroeconomic environment and firms' sales/earnings, which would result stability in firms' capital structure that help smooth firms' investments and production. Originality/value – Unlike prior empirical studies that mainly focus on examining the impact of risk on target leverage, this paper attempts to examine the influence of firm-specific and macroeconomic risk on firms' external financing decisions and debt-equity choices.

Why do managers avoid EPS dilution? Evidence from debt–equity choice

Survey evidence reveals that managers prefer to avoid dilution of earnings per share (EPS), though financial theory suggests it is irrelevant in firm valuation. We explore contracting and behavioral explanations for this apparent paradox using a large sample of debt–equity issuers. We first provide evidence that firms with greater agency conflicts between managers and shareholders are more likely to use EPS as a performance measure in bonus contracts. After controlling for possible endogeneity related to compensation contract design, we find that managers are more likely to avoid earnings dilution when their bonus compensation explicitly depends upon EPS performance. This effect is increasing in the magnitude of bonus compensation for this subset of firms; we document no such associations for the firms that do not use EPS in setting bonus pay. Additional tests of firms’ speed of adjustment to target leverage ratios and firms’ debt conservatism levels indicate that explicitly rewarding executives on EPS performance helps to resolve underleveraging problems. We also find that clientele effects are associated with managers’ aversion to earnings dilution. Our findings provide a deeper understanding of the factors that underlie the use of accounting performance in compensation contracts and new evidence on the implications of the contracting role of accounting in firm decision-making.

Determinants of Capital Structure: An Empirical Investigation of Malaysian Listed Government Linked Companies (GLCs)

This paper investigates the determinants of capital structure in Malaysian Listed Government Linked Companies (GLCs) using a sample of 13 GLCs from a period of 1997 to 2009. Using multiple regression analysis, the study explores how the debt equity choices of Listed Malaysian Government linked Companies (GLCs) are influenced by the firm specific characteristics and macroeconomic variables. Two elements of leverage that is book value of total debt ratio and long term debt ratio were used to check any significant changes in corporate financing and found a mixed result. Tangibility and firm Size are the most significant variables to determine the corporate financing of GLCs. Whilst liquidity and interest rate are negatively significant with the book value of the total debt ratio and the long term debt ratio respectively. In contrast, the outcome of the study demonstrates that economic growth does not play a major role in the debt equity choices of GLCs. The study concluded that profitability is inconsequential in determining corporate financing; inconsistent with the findings of previous Malaysian studies. The findings reveal that both Pecking Order and the Trade-off Theory are pertinent theories to the GLCs’ capital structure. With the proper design of the capital structure and intervention from the government, the study also concluded that GLCs are less reliant on leverage to support their investment.

Non-linearity in timing the equity market and debt-equity choice of UK firms.

Non-linearity in timing the equity market and debt-equity choice of UK firms.

Signaling Quality Through Debt-Equity Choice and Investment Timing

Signaling Quality Through Debt-Equity Choice and Investment Timing

Equity Market Timing and Capital Structure: Evidence from Tunisia and France

This paper investigates the relevance of market timing considerations on the debt-equity choice using a panelof tunisian and french listed firms. Consistent with the market timing theory, we find that firms tend to issueequity when their market valuations are relatively higher than their book values and after market performanceimprovement. As a consequence, these firms become underlevraged in the short-term and this impact of equitymarket timing on capital structure persists beyond eight years.

An application of the two-stage Bivariate Probit–Tobit model to corporate financing decisions

Most of the previous studies on the firms’ debt-equity choice utilize the standard single equation Probit (or logit) model as if firms face a single dichotomous decision to issue debt or equity, but not both. In this study, we examine the factors affecting the choice between internal and external funding and between debt and equity as well as the size of issues using a two stage Bivariate Probit-Tobit model. Our results indicate that the Bivariate-Probit estimation is more efficient than that of two independent Probit equations. An examination of factors that affect the choice of financing form and the size of issue support the predictions of trade-off theory. The pecking order’s prediction that, if external funding is needed, firms issue debt first and then equity finds no support in this study as firms with higher information asymmetry have propensity to issue equity rather than debt. While information asymmetry affects the choice between debt and equity, we find no evidence that it influences the size of issue.

In search of conclusive evidence: How to test for adjustment to target capital structure

Simulation experiments show that both partial-adjustment and debt-equity choice models can generate spuriously significant estimates that are consistent with the hypothesis that firms have target debt ratios to which they periodically adjust. Regressions relying on full-sample fixed effects models of target leverage, in particular, produce results severely biased in favor of the target-adjustment hypothesis. Various target proxies and modifications to the standard methodologies are examined to identify partial-adjustment and debt-equity choice models that have power to reject the target-adjustment hypothesis. The resulting estimates of the speed of adjustment are in the range of five-eight percent per year.

Multi-Stage Investment, Long-Term Asymmetric Information and Pecking Order Revisited

Following some recent empirical papers we focus on the key feature of Pecking-order theory (POT) - the existence and the extent of asymmetric information between firms' insiders and outsiders. We analyze the debt-equity choice for financing a two-stage investment and consider different informational structures. When private information is short-term, equilibria are consistent with POT. When private information is long-term and the extent of asymmetric information regarding firms values is small enough while that regarding the earnings profile over time is large enough, equilibria may exist where high quality firms issue equity which are not consistent with POT. This clarifies the role of asymmetric information in explaining equity issues and provides new tools for researchers testing POT.

In Search of Conclusive Evidence: How to Test for Adjustment to Target Capital Structure

Simulation experiments show that both partial adjustment and debt-equity choice models can generate spuriously significant estimates that are consistent with the hypothesis that firms have target debt ratios to which they periodically adjust. Regressions relying on full-sample fixed effects models of target leverage, in particular, produce results severely biased in favor of the target adjustment hypothesis. Various target proxies and modifications to the standard methodologies are examined to identify partial-adjustment and debt-equity choice models that have power to reject the target adjustment hypothesis. The resulting estimates of the speed of adjustment are in the range of five-thirteen percent per year.

Conditional Security Choice and the Use of Shelf Offerings

We analyze three decisions in the shelf registration process. Firstly, we examine the determinants of shelf registration statement type, namely universal, common stock, or debt shelf. Secondly, we examine the drivers of the firm’s issue decision, that is, whether or not the firm issues securities under any shelf registration. Thirdly, we analyze the determinants of the debt-equity choice under a universal shelf registration statement. The results show that firms that register equity or debt shelves have characteristics that are common to equity or debt issuers. Firms that register universal shelves, have characteristics similar to dual issuers. Further, we find that larger firms are more likely to conduct offerings under all types of shelf registration statements implying that small firms have limited access to the capital market. The determinants of the debt-equity choice for firms that have an effective universal shelf registration statement are consistent with the prior literature on security issue decisions and the main theories of capital structure. This implies that a firm’s external financing behavior has not changed due to adoption of Rule 415. Firms use shelf offerings in a similar way to traditional security issues in the debt-equity choice decision.

Corporate Capital Structure Choices in Mena: Empirical Evidence from Non-Listed Firms in Morocco

Based on their perceptions, more than three quarters of Moroccan manufacturing firms have identified access to finance as one of the major constraints affecting their performance. However, compared to a number of emerging countries, Moroccan firms appear relatively undercapitalized and more reliant on external finance. These two findings seem contradictory and have very different policy implications. The purpose of this paper is to provide a rigorous understanding of the rationale behind financial choices made by Moroccan firms, and assess the severity of financial constraints they effectively face. The paper uses a panel dataset covering 550 non-listed manufacturing firms over the period 1998–2003 and investigates both long-term and short-term measures of leverage with the objective of understanding the factors that shape “debt-equity choice” as well as “debt maturity structure”.Our analysis reveals the existence of a negative relationship between asset tangibility and both aggregate leverage and short-term debt ratio. However, no clear cut relationship between asset tangibility and long-term debt is uncovered. Small firms tend to increase their debt instead of opening their capital to outside investors and larger firms seem to rely much more on their retained earnings for their long-term financial needs. For short-term debt, size does not appear to matter. The impact of growth is positive on short-term leverage and irrelevant for long-term leverage. Finally, profitability exerts a positive effect on long-term leverage and a negative one on short-term leverage.

Financial constraints and security issuance

We examine the security issuance decisions of financially constrained firms. Since constrained firms are more susceptible to revenue management problems, our study sheds light on the financing behaviour of firms with revenue-related issues. Our results show that financially constrained firms obtain higher announcement returns than unconstrained firms when they issue bonds whereas the returns are similar when they issue stocks. Also, firms that face higher financial constraints are more likely to issue bonds than common stocks. We find that financially constrained firms assign different weights to the factors that affect the debt-equity choice than the weights assigned by unconstrained firms.