Do Tests of Capital

Structure Theory Mean

What They Say?
Ilya A. Strebulaev, Stanford University.

Introduction
Recent empirical research:
Focuses on regularities in the cross section of leverage to discriminate between
various theories of financing policy.
Support pecking order theory in face of cross section evidence.

The author:
Companies adjust their capital structure infrequently;
Proposes a dynamic model where at any time the majority of companies is not
at a refinancing point;
A model constructed using trade-off theory creates the same results that are
being used to support pecking order theory.

Question

Would our interpretation of cross-sectional tests change if firms

optimally adjusted their leverage only infrequently?

How the paper is organized

Section I - The model;
Section II - Simulation and empirical tests;
Section III - Robustness tests;

Section IV - Conclusion.

The Model

The Case of an All-Equity Firm

Economy populated by N firms;
Firm endowed with monopoly access to infinitely lived project;
Value of firm comes from present and future income from project;

Cash flows are invariant to financial policy (Miller and Modigliani)

Investment = Retained Earnings;
Book assets grow by g;
Claimholders = Equity, Debt, Gov., costs.

The Case of an All-Equity Firm

Net payout to claimholders, , is governed by:

and are constant;

is the risk neutral drift;
is the instanteneously volatility of the projects cash flow;
Z is a Brownian motion.

The Case of an All-Equity Firm

Shareholders value =

are taxes;

The Case of a Levered Firm

Debt is in the form of a perpetuity entitling debtholders to a stream
of continuos payments at the rate of c per annum;
Equity holders can call debt at any time at face value.

The Case of a Levered Firm

Path 1 retire outstanding debt; sell a new, larger issue to take
advantage of tax benefits associated with debt;
Path 2 and 3 sell fraction of assets to retire debt;
Path 2 same as path one;
Path 3 default;

The Case of a Levered Firm

Corrective action at Path 2 and 3 is modeled as follows.

Firm sells fraction 1 ;

D = par value of debt;
V = present value of project;
qA = proportional cost of selling assets;
qRC = adjustment costs of issuing/retiring debt.

Scaling feature

Since all costs are proportional to the value of the firm or its claims, at
any refinancing point, the firm is just a large replica of itself.

So...
Therefore, the values of equity and debt can be computed for four
different cenarios:

Firm is financially healthy (Path 1)

After it hits the liquidity barrier for the 1st time (Path 2 and 3)
After barrier is hit (Path 2)
Default (Path 3)

Equity
The values of equity in one refinancing cyle at time t = 0 is:

1st term is the PV when neither barriers have been reached;

2nd term is the PV after liquidity barrier has been reached;
3rd term is the valued received in default.

Debt
The values of debt in one refinancing cyle at time t = 0 is:

1st and 3rd term are the NPV of payout to debtholders before and after liquidity
crisis;
2nd term reflects debt purchased when assets are sold;
4th term reflects default.

Equity
The total value of all payouts to equity (except at refinincing points)
is given by:

Debt
The total value of all debt issues is:

Combining the two...

Combining these values yields the total value of the firm that equity
holders maximize at time t = 0:

And...
Equity holders choose the coupon and barriers to maximize the ex
ante value of their claim.

Net payout ratio

The author assumes the net payout ratio depends linearly on the
after tax coupon rate.

V = PV of all future payouts.

Did not understand

Numerical approach
Solving F() subject to Net Payout Ratio and the smoot passin
condition;
A closed-form solution to this problem does not exist, and thus
standard numerical procedures are used.

Simulation

Simulation
300 quarters of data for 3,000 firms;
To minimize impacts of initial conditions, drop the first 152 quarters;
This equals to one "economy";

Repeat simulations for 1,000 economies.

Parameters
Whenever possible, use other authors;
Complement with robustness tests.

Empirical Tests

Empirical Tests
First study whether cross-sectional results are different at refinancing
points;
Second use data from the model and run conventional cross-section
studies from other authors.

Regression analysis
Leverage-profitability relationship;
Leverage and stock returns;
Changes in leverage and mean reversion;

Regressions on subsamples.

Leverage-profitability relationship
Columns 2 to 4: the relationship between profitability and leverage
can be negative in a dynamic model even for the trade-off model;
An empiricist would likely interpret this finding as evidence in favor
of the pecking order argument and contrary to the predictions of the
trade-off model.

Leverage and stock returns

Welch (2004): U.S. corporations do not change their capital structure
to offset the mechanistic effect on leverage of changes in their stock
price;
Teh simulations clearly show that a model with small adjustment
costs can produce results on the persistence of leverage that are
consistent with those observed in reality.

The implied debt ratio shows the response of leverage only to changes in equity:
f1 = 1 means firms do not reajust at all;
f2 = 1 mean firms perfectly offset any change in equity.

Changes in leverage and mean reversion

Not surprisingly, leverage in the model is mean reverting;
Fama and French (2002) report similar numbers for mean reversion.

Regressions on subsamples
Profitability almost loses explanatory power on the active
subsample.

Robustness Tests

Concluding Remarks

Concluding Remarks
The properties of leverage in the cross section in true dynamics and
in comparative statics at refinancing points differ dramatically;
The model generates data that using methodologies commonly
employed in the literature may lead to the rejection of the model
itself as explanation of the data.