Optimal Capital Structure Review

Strebulaev A. Ilya (2007) discussed in article that optimal capital structure research based on regularities in the cross section of leverage to discriminate between various theories of financing policy. Researcher use book and market leverage and develop relationship with profitability, book to market and firm size. Changes in market leverage are largely explained by changes in equity value. Past book to market rations help to predict current capital structure. Firms use debt financing conservatively, and leverage of stable and profitable firms appears low. Even if firms have target leverage ratio they slowly moved toward it.

Strebulaev A. Ilya (2007)  observed that in a dynamic economy with frictions the leverage of most firms, most of the time, is likely to deviate from the optimal leverage as prescribed by models of optimal financial policy, since firms adjust leverage by issuing or retiring securities infrequently at refinancing points. Consequently, even if firms follow a certain model of financing, a static model may fail to explain differences between firms in the cross section since actual and optimal leverage differ. Among the many existing explanations of capital structure, only the trade off argument fully worked out dynamic theory that produces quantitative predictions about leverage ratios in dynamics. This theory suggests that firms arrive at their optimal capital structure by balancing the corporate tax advantage of debt against bankruptcy and agency costs.

By using dynamic trade off model Strebulaev A. Ilya (2007) showed that data are more consistent. In the model, firms are always on their optimal capital structure path, but due to adjustment costs, they refinance only occasionally. Small adjustment costs can lead to long waiting times and large change in leverage. Firms that perform consistency well re- leverage to exploit the tax shield of debt. Firms that perform poorly face a liquidity crisis and sell their assets to pay down debt. If their financial condition deteriorates still further, they resort to costly equity issuance to finance their debt payments and, when all other possibilities are exhausted, they default and ownership is transferred to debt holders.

Strebulaev A. Ilya (2007) used a methodology which is covering both quantitative and qualitative predictions of capital structure theories in a dynamic economy with infrequent adjustment. Strebulaev A. Ilya (2007) found that the properties of leverage in the cross section in true dynamics and in comparative statics at refinancing points differ dramatically.

Leary T. Mark and Michael R. Roberts (2005) found in their paper that the motivations behind corporate financing decisions are consistent with a dynamic re-balancing of leverage. They found that firms are significantly more likely to increase (decrease) leverage if their leverage is relatively low (high), if their leverage has been decreasing (accumulating), or if they have recently decreased (increased) their leverage through past financing decisions. Their result is consistent with both the dynamic tradeoff model and modified pecking order model. Their findings give significant response to both low and decreasing leverage and high or increasing leverage and it is consistent with the existence of a target range for leverage, as in the dynamic tradeoff model. However, the asymmetric magnitude of this effect is consistent with the dynamic pecking order’s prediction that firms are more concerned about excessively high leverage than excessively low leverage.

In addition, they found that more profitable firms and firms with greater cash balances are less likely to use external financing, while firms with large anticipated investment expenses are more likely to use external financing. Their result suggests that both the bankruptcy costs associated with debt financing and that information asymmetry costs associated with equity financing are important determinants of capital structure decisions.

Leary T. Mark and Michael R. Roberts (2005) observed that firms make adjustments to their capital structures with re-balancing motives. Their result showed that with a lot of internal equity or large cash flows firms are less likely to use external financing which is consistent with Myres and Majluf (1984) modified pecking order model. On the other hand firm with large capital expenditures are more likely to issue debt or equity. This dependency on internal funds and investment demand is consistent with the implications of the pecking order theory. Trade off theory result is mixed, impact of bankruptcy costs is clear, as debt retirement are highly sensitive to high levels of leverage or accumulating leverage. However, the effect of leverage on debt policy appears asymmetric in that debt issuance are less, though still significantly, sensitive to the level and change in leverage, as well as past leverage decreases. On the other hand, the negative coefficient on profitability in the debt issuance model casts some doubt on the static tradeoff view that firms use debt as a tax shield for operating profits or to mitigate free cash flow problems.

Bradley Michael et al. (1984) use cross sectional firm specific data to test for the existence of an optimal capital structure. They examined the cross sectional variations in firm leverage ratios to see if they are related to through time volatility of firm earnings, the relative amount of non debt tax shields like depreciation and tax credits, and the intensity of research and development and advertising  expenditures.  They developed a single period model and their model captures the essence of the tax advantage and bankruptcy costs trade off models, the agency costs of debt arguments, the potential loss of non debt tax shields in non default states, the differential personal tax rates between income from stocks and bonds and for this purpose they made various assumptions. Their result indicated that firm volatility is significant and negatively related to firm leverage ratios across the firms in the sample and level of advertising and research and development expense is related negatively to firm leverage. On the other hand non debt tax  shields  showed positive relation between leverage and the level of non debt tax shields, this non debt tax shield  result suggest that firms that invest heavily in tangible assets and thus generate relatively high levels of depreciation and tax credits, tend to  have higher financial leverage. 

 Bradley Michael et al. (1983) concluded that optimal firm leverage is related inversely to expected costs of financial distress and to the amount of non debt tax shields. Their simulation analysis demonstrates that if costs of financial distress are significant, optimal firm leverage is related inversely to the variability of firm earnings. Mao X Connie (2003) discusses in his paper that risk shifting and under investment problems examined in isolation, it is often asserted that more leverage exacerbates the debt agency problem. Such an assertion assumes that the two debt agency problems drive firms’ investment decision in the same direction, and neglects the potential interaction between the two.

He argued that the volatility of a firm’s cash flows increases with investment scale, or that a firm faces a potential project with cash flows positively correlated with the cash flows from its existing assets. In this case, increasing the scale of investment would increase the total volatility of the firm’s cash flows. In a leveraged firm equity holders would increase investment to increase firm risk, while their under investment incentives discourage them from investing. Therefore, the two incentive problems will affect the firm’s investment and debt policy in different directions.

Mao X Connie (2003) argues that interaction between the two debt agency problems has not been fully understood. He develop a simple model that captures both the risk shifting and the under investment problems. In the model a firm faces a discretionary investment decision, and the terminal firm value is a random variable whose mean and volatility both depend on the size of  the investment. Thus risk shifting and under investment incentives will affect the investment decision of a leverage firm in the same or different direction, and the total agency cost of debt will depend on the tradeoff between the two incentive problems.

 Mao X Connie (2003) says that if volatility of project cash flows increases with investment scale, risk shifting by equity holders will mitigate the under investment problem. This implies that, contrary to the conventional wisdom, the total agency cost of debt is not monotonically increasing with leverage. Further he suggested that for high growth firms, the optimal level of debt increases with the magnitude of marginal volatility of investment when marginal value of investment is positive but declines with the magnitude of marginal value of investment when marginal value of investment is negative. It is inverse in low growth firm. Empirical findings support these predictions.