Analysis on Shyam-Sunder and Myers, “Testing Static Tradeoff Against Pecking Order Models of Capital Structure”, Jfe 1999

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Finance Seminar
Homework #1 Capital Structure
Shyam-Sunder and Myers, “Testing Static Tradeoff Against Pecking Order Models of Capital Structure”, JFE 1999 1. What is the main research question of the paper? The theory of capital structure has been dominated by the search for optimal capital structure. It predicts reversion of the actual debt ratio towards a target or optimum, and it predicts a cross-sectional relation between average debt ratios and asset risk, profitability, tax status and asset type. The empirical literature seems to confirm these two predictions but they have not checked the statistical power of their tests against alternative hypotheses, say, the pecking order model.

2. What are the main findings? (1) A simple pecking order model explains much more of the time-series variance in actual debt ratios than a target adjustment model based on the static trade-off theory. (2) The pecking order hypothesis can be rejected if actual financing follows the target-adjustment specification.

3. According to the following two equations, how to test the Pecking Order Theory? How to interpret a and bPO ? (1) DEFt = DIVt + Xt + DWt + Rt - Ct (2) DDit = a + bPO DEFit + eit Ct = operating cash flows, after interest and taxes DIVt = dividend payments Xt = capital expenditures DWt = net increase in working capital Rt = current portion of long-term debt at start of period Dt = long-term debt outstanding At = net book assets, including net working capital dt = Dt / At , the book debt ratio As the pecking order model predicts, when firms need fund, they first consider internal fund, then low risk debt and new equity at last. So the changes in debt ratios are driven by the need for external funds. And DEF just represent the need for external fund. By running the regression on the second equation, we try to find the relationship between debt ratio and need for external fund. The intercept a stands for the debt change when the firm has no deficit or surplus. The coefficient bPO stands for the partial influence of DEF on debt changes: holding other effects the same, by how much will the debt change for 1 unit change in DEF. If pecking order tells the true story, then a should equal 0 and bPO should equal 1.

4a. According to the following equation, how to test the Static Tradeoff Theory? * DDit = a + bTA ( Dit - Dit-1 ) + eit


* where Dit is the target debt level for firm

i at time t .

As the trade-off model predicts, the debt ratio is mean-reversion. So if the debt ratio was higher than the optimum in last period, the firm should reduce debt in this period and vice verse. Thus the 1

equation use the difference between last period debt ratio and optimal ratio Dit -Dit-1 as the explanatory variable, to see its effect on new debt issued(retired). If the trade-off model holds, then we can expect a significant positive bTA .


4b. What is the problem of estimating this equation? How to deal with this problem? One of the target ratio is unobservable. We can solve the problem by starting with the historical mean of the debt ratio for each firm, which can be multiplied by total capital to obtain an estimated target debt level. Alternative specifications include a rolling target for each firm, using only historical information, and an adjustment process with lags of more than one year.

5. What evidence can you find from the table?

Results for the basic target-adjustment model are given in the first and fifth columns. We find constants close to zero, and significant adjustment coefficients of bTA =0.33 (Column 1) and

bTA =0.41 (Column 5).
The targets are based on sample mean debt ratios for each firm. 0.21 and 0.25, respectively.

R 2 s for the two specifications are

The even-numbered columns in Panel A of Table 2 give results for the simple pecking order. The results for gross debt issues, shown in the fourth column, are the most pertinent. The coefficient is b PO =0.85, which is the right...
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