Capital Structure Decisions: Which
Factors Are Reliably Important?
Murray Z. Frank and Vidhan K. Goyal∗
This paper examines the relative importance of many factors in the capital structure decisions of publicly traded American firms from 1950 to 2003. The most reliable factors for explaining market leverage are: median industry leverage (+ effect on leverage), market-to-book assets ratio (−), tangibility (+), profits (−), log of assets (+), and expected inflation (+). In addition, we find that dividend-paying firms tend to have lower leverage. When considering book leverage, somewhat similar effects are found. However, for book leverage, the impact of firm size, the market-to-book ratio, and the effect of inflation are not reliable. The empirical evidence seems reasonably consistent with some versions of the trade-off theory of capital structure.
When corporations decide on the use of debt finance, they are reallocating some expected future cash flows away from equity claimants in exchange for cash up front. The factors that drive this decision remain elusive despite a vast theoretical literature and decades of empirical tests. This stems in part from the fact that many of the empirical studies are aimed at providing support for a particular theory. The amount of evidence is large, and so it is often all too easy to provide some empirical support for almost any idea. This is fine for a given paper but more problematic for the overall development of our understanding of capital structure decisions. As a result, in recent decades the literature has not had a solid empirical basis to distinguish the strengths and the weaknesses of the main theories.
Which theories shall we take seriously? Naturally, opinions differ. Many theories of capital structure have been proposed. But only a few seem to have many advocates. Notably, most corporate finance textbooks point to the “trade-off theory” in which taxation and deadweight bankruptcy costs are key. Myers (1984) proposed the “pecking order theory” in which there is a financing hierarchy of retained earnings, debt, and then equity. Recently, the idea that firms engage in “market timing” has become popular. Finally, agency theory lurks in the background of much theoretical discussion. Agency concerns are often lumped into the trade-off framework broadly interpreted.
Advocates of these models frequently point to empirical evidence to support their preferred theory. Often reference is made to the survey by Harris and Raviv (1991) or to the empirical study
We thank Werner Antweiler, the late Michael Barclay, Bill Christie (the Editor), Sudipto Dasgupta, John Graham, Keith Head, Kai Li, William Lim, Michael Lemmon, Ernst Maug, Vojislav Maksimovic, Ron Masulis, Jay Ritter, Sheridan Titman, Ivo Welch, Jeff Wurgler; seminar participants at Tulane University and Queen’s University; participants at the 2004 American Finance Association Meetings and the 2004 NTU International Conference; and especially our anonymous referees for helpful comments. Murray Z. Frank thanks Piper Jaffray for financial support. Vidhan K. Goyal thanks the Research Grants Council of Hong Kong (Project number: HKUST6489/06H) for financial support. ∗
Murray Z. Frank is the Piper Jaffray Professor of Finance at the University of Minnesota in Minneapolis, MN. Vidhan K. Goyal is a Professor of Finance at the Hong Kong University of Science and Technology in Clear Water Bay, Kowloon, Hong Kong.
Financial Management • Spring 2009 • pages 1 - 37
by Titman and Wessels (1988). These two classic papers illustrate a serious empirical problem. They disagree over basic facts.
According to Harris and Raviv (1991, p. 334), the available studies “generally agree that leverage increases with fixed assets, nondebt tax shields, growth opportunities, and firm size and decreases with volatility, advertising expenditures, research and development expenditures,...
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