Optimal Capital Structure Model Research Articles

Do political connections cause over-indebtedness? Empirical evidence from China’s listed construction firms

PurposeThis study aims to investigate the relationship between political connections and the over-indebtedness of firms in the construction industry. Furthermore, this study explores the moderating effect of corporate governance mechanisms with monitoring intent on this relationship.Design/methodology/approachThis study uses the data from China’s listed construction firms for the years 2010–2019 to run the fixed-effect regression. This study constructs the optimal capital structure mathematical model by following the trade-off approach.FindingsThe research results show that most of China’s listed construction firms are surprisingly over-indebted in the long run. This study affirms that political connections positively impact the over-indebtedness of China’s listed construction firms. However, corporate governance can alleviate the impact of political connections on the over-indebtedness of China’s listed construction firms.Originality/valueThere were limited studies to discuss the relationship between political connections and the over-indebtedness of construction firms, and no particular attention has been given to the moderating effect of corporate governance mechanisms on the relationship between political connections and over-indebtedness. Moreover, in calculating the over-indebtedness of China’s listed construction firms, this study considers the financial characteristics of China’s construction firms when building the mathematical model of optimal capital structure, which makes the calculation results of over-indebtedness closer to reality.

Financial reporting quality and optimal capital structure

AbstractWe investigate the role of financial reporting quality in reducing a firm's over‐ and underleverage problems. While the prior literature examining reporting quality and capital structure has focused on observed capital structure, research suggests that financing frictions arising from adverse selection concerns can result in differences between observed and optimal capital structures. Using the deviation from a predicted model of optimal capital structure, we find that approximately a third of firms that have more leverage than their industry's median firm are in fact underlevered and more than 15% of firms that have less leverage than their industry's median firm are in fact overlevered. Building off a large literature that provides evidence that financial reporting quality can mitigate adverse selection concerns and reduce financing frictions, we find that a firm's deviation from the predicted model of optimal capital structure is decreasing in financial reporting quality, and these results are larger in magnitude for firms that are overlevered.

Optimal Capital Structure under Stochastic Interest Rates with Endogenous Default Barriers

Based on the principle of maximization of the utility value for shareholders, we establish an optimal capital structure model under stochastic interest rates with improved endogenous default barriers by considering the tax and bankruptcy risk. From the numerical results, we find the drift and volatility of the firm’s log return, the average risk aversion of all the shareholders, the long term mean level of interest rate and the bond maturity are the key variables in determining optimal capital structure. We also find that the utility values behave as a concave function with bond principals. We can conclude that there exists an optimal amount of bond issuance to maximize the utility value of shareholders.

Credit default swaps, the leverage effect, and cross-sectional predictability of equity and firm asset volatility

Leverage represents both a fundamental component of equity volatility and a long-run selection variable. Based on this premise, we investigate the influence of leverage on the long-run cross-sectional predictability of future realized equity volatility. Leverage makes equity volatility significantly less predictable than underlying firm asset volatility, a result that is robust to different predictors of future realized volatility: credit default swap implied, historical, and option implied volatility. A simple model of optimal capital structure, wherein companies maximize tax benefits subject to a common maximum default probability (minimum credit rating) target, helps explain this finding.

Capital structure optimization: a model of optimal capital structure from the aspect of capital cost and corporate value

The purpose of this study is, firstly, to examine capital structure optimization and secondly, to provide a framework for determining the optimal capital structure from the aspect of capital cost and corporate value. The results of our work provide an innovative model for arriving at a company’s optimal capital structure based on the estimation of the effective cost of capital and the determination of the shares of new equity and long-term debt that will both minimize the overall cost of capital and maximize its value. The model can be applied for quantitative estimates of optimal capital structure. This paper contributes to the literature by applying mathematical modeling and mathematical theory of optimization to solve the problem of capital structure optimization, and by providing a framework for determining optimal capital structure. The scientific contribution of this research is development of a model of optimal capital structure from the aspect of capital cost and corporate value, and new equations for calculating the effective costs of long-term financing sources. This model provides explicit advice on optimal long-term debt and equity level and can be applied to produce a firm-specific recommendation about optimal capital structure that a given company should use.

Optimal Capital Structure with Imperfect Competition

Abstract We develop a model of optimal capital structure in imperfectly competitive markets by focusing on a duopoly. The model endogenizes both the financing and investment decisions of firms. We show that in equilibrium the industry leader uses debt conservatively, while the follower uses debt more aggressively and, as the result, defaults first. The model generates novel predictions about the leverage choices of the leader and the follower, their default likelihood, and the degree of leverage dispersion between competing firms. These predictions are strongly supported by the data. (JEL G13, G34, L13)

Effects of Positive Jumps of Assets on Endogenous Bankruptcy and Optimal Capital Structure: Continuous- and Periodic-Observation Models

In this paper, we study the optimal capital structure model with endogenous bankruptcy when the firm's asset value follows an exponential Levy process with positive jumps. In the Leland--Toft frame...

The Leland\u2013Toft optimal capital structure model under Poisson observations

This paper revisits the optimal capital structure model with endogenous bankruptcy, first studied by Leland (J. Finance 49:1213–1252, 1994) and Leland and Toft (J. Finance 51:987–1019, 1996). Unlike in the standard case where shareholders continuously observe the asset value and bankruptcy is executed instantaneously without delay, the information of the asset value is assumed to be updated periodically at the jump times of an independent Poisson process. Under a spectrally negative Lévy model, we obtain the optimal bankruptcy strategy and the corresponding capital structure. A series of numerical studies provide an analysis of the sensitivity, with respect to the observation frequency, of the optimal strategies, optimal leverage and credit spreads.

The optimal capital structure of Swiss dairy farms

PurposeThe purpose of this paper is to propose a novel way of determining optimal capital structure, applied to sub-groups of Swiss dairy farms from 2003 to 2014. Optimization of capital structure is carried out with respect to two performance indicators from an economic value added perspective.Design/methodology/approachOptimal values of capital structure are obtained based on a minimization of correlation between economic performance indicators and a distance function of the debt-to-asset ratio distribution to its quantiles. The approach differs from existing approaches in relying solely on empirical data and in using fewer external parameters, which are difficult to estimate, such as risk aversion coefficients. An unbalanced panel data set from the Swiss Farm Accounting Network with almost 14,000 dairy farm observations serves as input data to the model.FindingsConcise optimal values of capital structure result for regional and temporal sub-groups of Swiss dairy farms. Comparing the evolution of optimal values for these sub-groups with existing models of optimal capital structure, the authors infer that dairy farmers in the mountain region are less risk averse than their counterparts in the valley region and that falling interest rates increase the optimal value of debt-to-asset ratio.Originality/valueThe straightforward computation of optimal values for capital structure without intermediate parameters is useful and new. In addition, the authors’ model can be used as a tool for comparison and validation of previous models with the same aim, e.g. for comparison of risk aversion coefficients or qualitative behavior of optimal values for capital structure.

The Leland-Toft Optimal Capital Structure Model Under Poisson Observations

We revisit the optimal capital structure model with endogenous bankruptcy first studied by Leland (1994) and Leland and Toft (1996). Differently from the standard case, where shareholders observe continuously the asset value and bankruptcy is executed instantaneously without delay, we assume that the information of the asset value is updated only at intervals, modeled by the jump times of an independent Poisson process. Under the spectrally negative Levy model, we obtain the optimal bankruptcy strategy and the corresponding capital structure. A series of numerical studies are given to analyze the sensitivity of observation frequency on the optimal solutions, the optimal leverage and the credit spreads.

Contingent Debt and Performance Pricing in an Optimal Capital Structure Model with Financial Distress and Reorganization

Building on the trade-off between agency costs and monitoring costs, we develop a dynamic theory of optimal capital structure with financial distress and reorganization. Costly monitoring eliminates the agency friction and thus the risk of inefficient liquidation. Our key assumption is that monitoring cannot be applied instantaneously. Rather, transitions between agency and monitoring are subject to search frictions. In the optimal contract, the firm seeks a monitoring opportunity whenever it is financially distressed, i.e., when the risk of liquidation is high. If a monitoring opportunity arrives in time, the manager is dismissed, the capital structure is reorganized as in Chapter 11 bankruptcy, and the search for a new manager begins. In agency, an optimal capital structure consists of equity, long-term debt, contingent long-term debt, and a credit line with performance pricing. In financial distress, coupon payments to contingent debt are suspended but the interest rate on the credit line is stepped-up, which gives the firm simultaneously debt relief and a steep incentive to improve its financial position. An episode of distress can end with financial recovery, transition to bankruptcy reorganization, or liquidation.

Do Country and Industry Patterns Contribute to an Optimal Capital Structure?

We investigate evidence the existence of optimal capital structure and carry out an examination across countries and industries to detect systematic capital structure differences. In particular, we examine whether firms aim for an optimal capital structure through changing their debt ratios over time. We find evidence for the presence of systematic patterns in debt ratios and in the ways firms adjust their capital structures. This is indirect evidence for the optimal capital structure model and suggests firms seek the correct capital structure based on firm, industry, and country factors.

Uloga industrijskih faktora u optimalnoj strukturi kapitala - empirijska studija o proizvodnim preduzećima iz Indonezije

The objective of this study is to improve the model of optimal capital structure. This research aims to investigate the role of the industrial factors on the optimal capital structure proxy by including industry factors in the existing model and using the company characteristic variables as control variables. This research applies seven industrial variables: Number of Firms in Industry (NFI), Industry Competitive Dynamic (ICD), Firm Response to Industry Competitive (FRI), Numbers of Employees in an Industry (NEI), Employees' Share of Firm Quasi Rents (ESQ), Category of Product Diversification (CPD), and Diversification level of Relatedness (DRD). This research determines whether the proposed proxy in this research is better than the two other proxies. The testing procedure is designed to replicate the procedure of Farhat (2003). The data used in the study consist of 83 companies from 13 industries listed on IDX for the period of 2001-2014. The results showed that the industry variables can improve the existing optimal capital structure proxies. This finding contributes to the industry in that it can improve the dynamic trade-off model of capital structure.

The Moderating Role of Debt Financing on the Relationship Between Leverage and Performance: An Empirical Analysis of the Textile Sector of Pakistan

The study examines how debt financing affects the leverage and performance relationship of the textile sector of Pakistan. The study also strives to elaborate the determinants of debt financing. Data has been collected from the annual reports of the textile companies listed at Pakistan Stock Exchange (PSE) for the years 2010-2015. Panel data techniques including Pooled OLS, Fixed Effect model, Random Effect model, and Moderated Panel Regression model were used for estimating the relationship between debt ratio, leverage and company-specific variables such as profitability and size. The results depict that the listed textile companies of Pakistan financed more than half of its assets by external borrowing. There is high asset tangibility in the Pakistani textile industry. The tax shield, which is the alternative of depreciation, is limited for the textile firms of Pakistan (Qamar, Farooq, Afzal & Akhtar, 2016). The independent variables’ interaction term with debt ratio shows a positive relationship with ROA other than asset tangibility. The trade-off theory suggests to follow a targeted optimal capital structure which is more favorable for a firm. Pakistani textile industry should adopt the model of optimal capital structure for balancing the costs and benefits.

Dynamic Model of Optimal Capital Structure: Evidence from Nigerian Listed Firms

Examination of optimal capital structure in financial markets with imperfections suggests that when deviations from optimal capital structure occur, adjustment costs may prevent firms from moving towards target capital structure. However, previous studies on the capital structure of non-financial firms in Nigeria did not consider these imperfections and adjustment costs. It is against this background that this study investigates the dynamic adjustment to target capital structure by non-financial firms listed on the Nigerian Stock Exchange. By utilizing a framework that provides for the determination of adjustment costs, the results reveal the existence of dynamic adjustment to optimal capital structure suggesting attempts made by the sampled firms to maximize shareholders wealth. A comparison of the adjustment costs with those of firms in more developed economies shows that Nigerian firms have higher costs of adjustment indicating that the level of development of the market is important in lowering transaction costs. In addition, tangibility of assets, non-debt tax shield, growth opportunity, firm size, profitability and inflation significantly influence Nigerian firms’ optimal capital structure.

Optimal capital structure with moral hazard

This paper extends the classic optimal capital structure model to the case of moral hazard based on the principal-agent problem, where the firm's output dynamically depends on the agent's efforts. We derive closed-form results for the value of risky debt, credit spread, default threshold, and for optimal capital structure with moral hazard. The numerical results indicate that the firm issues more debt with higher coupon ex ante and defaults earlier ex post than without manager moral hazard. The different initial values of firms' cash flow induce different risk preferences of the manager to his value and consequently the manager acts in the opposite approaches especially when the firm is on the verge of bankruptcy. The paper also consider the occasions in which hiring a manager is optimal for the principal.

Another Dark Side of IRR - Excessive Leverage, Increased Default Risk and Wealth Destruction

The internal rate of return (IRR) is still a widespread criterion for investment decisions, although many pitfalls are well known. This paper provides evidence for another, more fundamental, dark side of IRR: Based on a dynamic model of optimal capital structure with endogenous bankruptcy trigger and risk-adjusted yield of debt we show that capital structures maximizing IRR are suboptimal, i.e., not value maximizing. The IRR criterion triggers the choice of higher leverage increasing the risk of default. Depending on the parameter setting the net benefit of financing reduces by up to 50 per cent. As optimizing the financing structure based on IRR is popular in PE related settings, our results are especially important for this industry.

Struktur Modal dan Kinerja Perusahaan (Studi pada perusahaan yang terdaftar di Bursa Efek Indonesia periode 2011 s/d 2012)

Abstract This paper examine the impact of capital structure on firm performance, in Indonesian Stock Exchange. Firm performance are analyzed from the side of accounting indicators, in this research use liquidity. Because the optimal level of debt of the firm is limited by the liquidity of the assets and it depends on the average usage of the debt in the particular industry. In the other side liquidity is conventionally seen as reflecting investors’ degree of risk -aversion, The study collects of listed firms in Indonesian Stock Exchanges during 2011 to 2012. The listed firms on sub sector trade, services and investment. Multiple Regression analysis approach was employed in carrying out this analysis. Specifically, determined the simultaneous relationships among the various variables. The results show that as partial total debt to asset significantly influences to company’s performance but long term debt to asset not significantly influences to company’s performance. Simultaneously, total debt to asset and long term debt to asset influences company’s performance. This evidence is consistent with models of optimal capital structure and with the hypothesis that debt level changes release information about changes in firm value/performance.

Optimal Capital Structure with Scale Effects under Spectrally Negative Levy Models

The optimal capital structure model with endogenous bankruptcy was first studied by Leland (1994) and Leland and Toft (1996), and was later extended to the spectrally negative Levy model by Hilberink and Rogers (2002) and Kyprianou and Surya (2007). This paper incorporates scale effects by allowing the values of bankruptcy costs and tax benefits to be dependent on the firm's asset value. These effects have been empirically shown, among others, in Warner (1976), Ang et al. (1982), and Graham and Smith (1999). By using the fluctuation identities for the spectrally negative Levy process, we obtain a candidate bankruptcy level as well as a sufficient condition for optimality. The optimality holds in particular when, monotonically in the asset value, the value of tax benefits is increasing, the loss amount at bankruptcy is increasing, and its proportion relative to the asset value is decreasing. The solution admits a semi-explicit form, and this allows for instant computation of the optimal bankruptcy levels, equity/debt/firm values and optimal leverage ratios. A series of numerical studies are given to analyze the impacts of scale effects on the default strategy and the optimal capital structure.

Debt, Taxes, and Liquidity

We analyze a model of optimal capital structure and liquidity choice based on a dynamic tradeoff theory for financially constrained firms. In addition to the classical tradeoff between the expected tax advantages of and bankruptcy costs, we introduce a cost of external financing for the firm, which generates a precautionary demand for liquidity and an optimal liquidity management policy for the firm. An important new cost of financing in this context is an endogenous servicing cost: payments drain the firm's valuable liquidity reserves and thus impose higher expected external financing costs on the firm. The precautionary demand for liquidity also means that realized earnings are separated in time from payouts to shareholders, implying that the classical Miller-formula for the net tax benefits of no longer holds. Our model offers a novel perspective for the debt conservatism puzzle by showing that financially constrained firms choose to limit usages in order to preserve their liquidity. In some cases, they may not even exhaust their risk-free capacity.