Capital Structure Decisions

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Capital Structure Decisions: Which Factors are Reliably Important? Murray Z. Frank1 and Vidhan K. Goyal2

First draft: March 14, 2003. Current draft: December 20, 2003. ABSTRACT This paper examines the relative importance of 38 factors in the leverage decisions of publicly traded U.S. firms from 1950 to 2000. The most reliable factors are median industry leverage (+ effect on leverage), market-to-book ratio (-), collateral (+), bankruptcy risk as measured by Altman’s Z-Score (-), dividend-paying (-), log of sales (+), and expected inflation (+). These seven factors all have the sign predicted by the trade-off theory. The pecking order and market timing theories are not as helpful in predicting the importance and the signs of the reliable factors. For large, mature, dividend-paying firms, leverage is negatively related to profits. This relationship is not reliably important in the broader population of firms. JEL classification: G32 Keywords: Capital structure, pecking order, trade-off theory, market timing, multiple imputation.

1 Faculty of Commerce, University of British Columbia, Vancouver BC, Canada V6T 1Z2. Phone: 604-8228480, Fax: 604-822-8477, E-mail: Thanks to Werner Antweiler and Kai Li for helpful comments. We alone are responsible for any errors. Murray Frank thanks the BI Ghert Family Foundation and the SSHRC for financial support. 2 Department of Finance, Hong Kong University of Science and Technology, Clear Water Bay, Kowloon, Hong Kong. Phone: +852 2358-7678, Fax: +852 2358-1749, E-mail:

I. Introduction
What factors determine the capital structure decisions made by publicly traded U.S. firms? Despite decades of intensive research, there is a surprising lack of consensus even about many of the basic empirical facts. This is unfortunate for financial theory since disagreement over basic facts implies disagreement about desirable features for theories. This is also unfortunate for empirical research in corporate finance; if an empirical researcher wants to offer new empirical insights, it may be unclear what other factors need to be controlled. The need for a basic set of empirical facts about capital structure decisions is often handled by making reference to the survey by Harris and Raviv (1991), or to the empirical study by Titman and Wessels (1988). These two classic papers illustrate the problem of disagreements over basic facts. According to Harris and Raviv (1991, page 334), the available studies “generally agree that leverage increases with fixed assets, non-debt tax shields, growth opportunities, and firm size and decreases with volatility, advertising expenditures, research and development expenditures, bankruptcy probability, profitability and uniqueness of the product.” However, Titman and Wessels (1988, page 17) find that their “results do not provide support for an effect on debt ratios arising from non-debt tax shields, volatility, collateral value, or future growth.” Consequently, different studies employ different factors to control for what is ‘already known’. This study contributes to our understanding of capital structure in several ways. First, a level playing field is created that includes 38 factors. This set of factors includes the major factors considered in the literature. Much of the analysis is devoted to determining which factors are reliably signed, and reliably important, for predicting leverage. Second, there is good reason to suspect that pattern of corporate financing decisions might have changed over the decades. During the 1980s, many firms took on extra leverage apparently due to pressure from the market for corporate control. During the late 1980s and the 1990s, many more small firms made use of publicly traded equity. Other factors may also have changed. It is therefore important to examine the changes over time. Finally, it has been argued that different theories apply to firms under different circumstances. “There is no universal theory of...
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