Capital Structure Issues

- Dissertation proposal
H.Thorsell
+
Center for Financial Analysis and Managerial Economics in Accounting
Stockholm School of Economics
Dissertation Proposal
(No. 2.5)
May 2006
Abstract
The proposed study consists of three topics; corporate bond pricing and CAPM,
capital structure trade-o versus historical chance, and trade credits. The con-
tribution of this proposal is the description of the projects and a short literature
review.
The expected contributions of the proposed studies are to test if the pricing of
corporate bonds is consistent with CAPM, a head to head test between the trade-
o and the historical chance theories, and an investigation into why there are trade
credits in developed nancial markets.
Keywords: Bankruptcy; Capital Structure; Dissertation proposal.
JEL codes: G32.
Acknowledgement: Thanks for valuable input Hanna, Henrik, Katerina, Johan,
John, Kenth, and Tomas!
1
Stockholm School of Economics, P.O. Box 6501, SE-113 83 Stockholm, Sweden

Hakan.Thorsell@hhs.se
1
All remaining errors in this proposal are of course my own.
1 Introduction
Assets of a company have to be acquired, bought for cash or created. The mirror image
of the assets of a company is the nancing necessary for balancing the books. The choices
and decisions regarding the use of nancial obligations on behalf of the owners is the
nancial policy, and the resulting composition of the nancial obligations of a company
is the capital structure.
The capital structure decision is a complex problem in operating any company or
business, since there are many possible choices. Three examples of parameters that can
be varied are debt-to-assets ratio, duration of liabilities, and currency choice. Even if
the choice of nancial policy is important for the operations and daily management of
a company, does the nancial policy matter for the owners or other outsiders? Does
the choice of nancial policy change the value of the company? These issues were rst
explicitly treated by Modigliani and Miller (1958) and led to their famous propositions.
The propositions and the questions raised dened the research eld of corporate nance
during the following decade. After the propositions there has been a huge amount of
research, testing, expanding, and trying to answer the capital structure questions. No
really satisfactory answer has been reached and the returns to the research have not yet
reached a steady state.
The aim of this paper is to propose research questions related to capital structure and
to outline a plan of investigation. Specically the focus will be on three issues; Default
risk in corporate bond pricing, capital structure trade-o versus historical chance, and
explaining trade credits.
In the next sub-section the research issues are discussed. The suggested papers are
presented in sections two, three and four. In each section, there is a short description of
earlier literature, the question, the suggested method and potential contributions. The
potential over all contributions to the literature are presented in section ve. In section
six practical considerations are presented (time schedule).
1.1 Research issues and objectives
Companies have dierent capital structures and these structures are studied at the micro-
level of corporate nance. The theories of the rm are the intellectual backbone for
corporate nance according to Zingales (2000), and the results in these lines of research
often correspond closely. If the rm is considered to simply be a nexus of contracts, the
rm has no stand-alone value, and the rm cannot be more valuable than the sum of the
parts, exactly as shown by Modigliani and Miller (1958). Since the size of the pie doesnt
change, the assets of the company completely determine the total value of the rm
2
. If
2
Value refers to the priced nancial obligations, and total value refers to the value of all capital used
by the company.
1
the theory of the rm is assumed to be slightly richer, for instance by including implicit
contracts, then the size of the pie might change. One factor that can change the size
of the pie is the bankruptcy risk, and another is rm specic investment. An employee
that thinks the risk is high that the rm might be liquidated might not undertake any
rm specic investments (like enhancing his skills) even if it would be valuable for the
company.
The empirical studies of capital structure choices reveal many dierent choices. One
empirical observation is that the choice of nancial structure seems to be industry specic
to some extent, for example forestry companies have similar capitalizations. Titman and
Wessels (1988) nd that rms with specialized products tend to have lower debt ratios,
indicating that industry clustering exists. This nding does not in itself contradict the
irrelevance of the choice of nancial policy, but is it a coincidence? Another observation
is that, even though investors can undo the choice of nancial policy, it does not seem to
happen in practice. It should be visible in portfolio mandates or mutual funds investment
guidelines if investors considered the capital structure an issue. It is of course possible
that the professional participants in the market place have the same view on the proper
capitalization of the companies they invest in, but it seems slightly unlikely. Investors
do not motivate cash or debt allocation in portfolios with too high/low leverage of the
portfolio companies.
1.1.1 Summary
The research issues that are proposed to be treated in the dissertation are default risk
in corporate bond pricing, capital structure trade-o versus historical chance, and trade
credits.
The compensation for holding a corporate bond is typically 30-50 basis points above
the government bond rate. The , has to be low to motivate this spread. Why is the
, low? Can the higher yield of corporate bonds be explained by risk of bankruptcy?
The irrelevance propositions and the trade-o theory are well established in the
capital structure literature. There has only been one earlier attempt to pitch the
two theories against each other
3
. Can the irrelevance and trade-o hypothesis be
tested by a unit-root test?
In the literature on capital structure, the natural object of study is the rm. If there
is no dependence between nancial policy and operating policy the irrelevance results
are valid. Many authors have suggested models with dependence between nancial
and operating policy, one example being the industry clustering. Since rms dont
exist in isolation, it might also be the case that the nancial policy of a rm is also
3
Castanias (1983) tested the cross-section of business risk against leverage and is the closest test in
the literature.
2
dependent on the choices of other rms? Can trade credits be used to examine this
inter-rm dependence, or vertical integration of capital structure?
2 Default risk in corporate bond pricing
Nandi (1998), Uhrig-Homberg (2002) and others divide the corporate bond pricing mod-
els into two classes, the structural models and the reduced form models (RFM). The
structural models use insights from option pricing theory
4
, where the equity owners have
a long call option and the debt-owners have an issued put option on the assets of the
company. To use the structural model to value the debt, some data is necessary; such
as the value of the assets, face value of the debt, volatility of the assets and the risk-free
bond yield for the same maturity as the debt. The residual parameter in a structural
model is typically the spread between the corporate debt and the risk-free rate. There
are two common explanatory factors for this spread; the credit risk of the company and
the liquidity premium for the bond. In a structural model, Ericsson and Reneby (2003)
nd their corporate bond pricing errors to be largely diversiable, but also that there is
a nonnegotiable systematic risk. In contrast to the structural model, the reduced form
models typically assume that the bankruptcy event is exogenous. A very simple case of a
reduced form model would thus be a discounted cash ow model adjusted with the proba-
bility of bankruptcy. The major advantage of the RFM over structural models is that the
RFM are not as dependent on data that is hard or dicult to obtain, such as the market
value and volatility of the assets. On the other hand, the RFM do not use the information
from the capital structure of the company. One particular RFM is the CAPM family of
models. Despite the well known problems
5
of CAPM it is a well established model for
pricing assets.
In contrast to the government bond valuation problem, there is substantial room to
include specic risks in a corporate bond valuation, three obvious candidate risks are
non-diversication in income, risk shifting and asset substitution. The government bond
is backed by the taxpayers income and the rm is only backed by an income ow from
operating in a product market. Governments have a diversied asset-base and can
increase income by means not available to companies. After the company has issued
bonds, it can change its business risk and/or change its asset composition, and thus
expose the bond owners to more risk than they originally anticipated
6
.
The classic works of Modigliani and Miller (1958) and Stiglitz (1969) depend on the
4
see Merton (1974).
5
Two well known problems are 1) CAPM cannot explain returns with reasonable risk aversions and
2) CAPM appear to be rejected in tests not because it is wrong but because the proxies for the market
return are not close enough to the true market portfolio (Rolls critique).
6
Typically the buyers of bonds protect themselves with covenants that limit the asset substitution
problem. It could be argued that this just introduces a monitoring problem.
3
value of the whole to equal the sum of the value of the parts. A contract is not more
valuable in any specic nexus, i.e. the sum of marginal contributions from all contracts
equal the value of the rm. It does not matter how the pie is sliced. In an incomplete
contract setting it does matter how the pie is sliced. Leland (1994) shows the value
of corporate bonds to be jointly determined with the capital structure in his structural
model. Leland derives, among other things, a closed form solution to the pricing of long-
term risky debt. A slightly surprising nding is that yield spreads of junk bonds might
decrease with increasing risk
7
, and shareholders benets from the rm including protective
covenants when issuing bonds
8
.
Asquith, Gertner and Scharfstein (1994) investigate how rms restructure in distress
and nd that the restructuring process is dependent on the preceding capital structure.
Asquith et al. (1994) also investigate how rms deal with nancial distress. Firms get
out of the distress situation by using asset sales, mergers, capital expenditure reductions,
layos, restructuring of bank debt and public debt. In essence the ways to handle nancial
distress are either to increase the results and/or cash-ow from operations or to change
the nancial structure. Asquith et al. (1994) nd that a rms debt structure aects
the way it restructures if distressed. According to Asquith et al. (1994) the sources of
nancial distress are (1) high interest expense, (2) poor operating performance, and (3)
an industry downturn. Asquith et al. (1994) nd that rms have used dierent routes for
solving their nancial distress:
Bank debt restructuring. Banks can loosen or tighten nancial constraints in a nan-
cial distress situation. The increased exibility of a rm when the bank has loosened
the constraints is not always benecial as 59% still go into bankruptcy. When the
banks tighten the constraint, in contrast, as many as 68 % go into bankruptcy.
Public debt restructuring. The 76% of rms in the sample that did not restructure
their public debt all went into bankruptcy. The high number of rms doing public
debt restructuring is surprising since there should be a substantial free-rider problem
(small debt owners have no impact on the outcome but still bear some cost).
Asset sales. Firms that sell o assets have a markedly lower likelihood to go into
bankruptcy. In the sample of Asquith et al. (1994), only 3 out of 18 rms that sell
more than 20% of their assets go into bankruptcy. Companies in poorly performing
or highly leveraged industries are less likely to sell assets.
Debt structure. Companies with more secured debt and more complex debt structures
are more likely to seek bankruptcy protection.
7
This is surprising and is most likely an eect of Lelands model. The characteristics of the junk-bonds
get closer to equity the junkier they become.
8
This is also slightly surprising since the equity owners would not have a claim to the assets before
the debt-owners anyway.
4
Performance. There is no evidence that better performing companies in distress fare
better in dealing with nancial distress.
Capital expenditure. 83% of the rms in the sample have large reductions in their
capital expenditure.
The valuation of a single corporate bond depends on the resolution of claims in nan-
cial distress. Baldwin and Mason (1983) examine the case of Massey Ferguson, and the
conclusion is that the market expects the debt and equity owners to re-contract before
the equity is eradicated. This is in line with the later ndings of Gilson (1997), that
chapter eleven is a credible threat when bargaining for re-construction. Companies in
highly leveraged industries tend not to sell o assets in a distress situation. The attitude
towards debt has changed over time, in Donaldson (1961) the attitudes against debt is
examined and the decision rules are No long term debt under no circumstances, borrow
the maximum available, and many similar headings. The point is that corporate man-
agers viewed debt as something to avoid at almost any cost, and that the judgment of
how much debt a company should take on was best left to the bank manager. This aver-
sion towards debt changed over time. The high-leverage-transactions (HLT) of Andrade
and Kaplan (1998) would have been unthinkable during the 1960s. Andrade and Kaplan
argue there is a dierence between economic cost and nancial costs in distress, where
only the latter should inuence the ex-ante capital structure. The rms in their sample
are in distress, but have a higher operating margin than the average of their respective
industries. The costs of nancial distress are estimated to be 10-20% of rm value.
Most empirical studies have focused on the distressed rms, but the spread exists also
for rms not in distress. Can spreads be interpreted as a cost of expected future distress?
2.1 Question
When investors value a single corporate bond, the capital choices of the company inuence
the estimated price, since the investors will want to make sure the company can repay.
The value of a single bond is sensitive to the market opportunities, protability and
capitalization of the company. In short the theoretical (single) bond value is sensitive
to the bankruptcy risk and the bankruptcy costs of the company. The spread between
corporate bonds and government bonds increases with lower credit rating of the company,
as can be seen in Figure 1 below.
5
Figure 1. The credit spread of the Eurodollar bond market.
Corporate bonds have a higher yield than government bonds. During the last seven
years, the spread between a basket of Swedish AAA (1-3 years) corporate bonds and a
basket of Swedish (1-3 years) government bonds has been 0.34 % on an annual basis
9
. The
spread between lower grade corporate and government bonds is much higher. The puzzle
is that according to CAPM the company specic risk should not command a premium,
since the company specic risk can be diversied. Dene 1
p
as the promised yield on a
risky corporate bond and 1
f
the yield on a risk-free bond. If the specic risk in a corporate
bond portfolio can be eliminated, why then should the spread (1
p
1
f
) co-vary with the
market?
The question now is why bond spreads can be observed in pricing? An investor should
be able to diversify until the spread disappears, unless there are systematic risks. There
might be explanations for the spreads; a prime candidate is that companies are all at the
mercy of the markets in a dierent way than the government. This non-diversiable risk
should be possible to quantify in the , value.
At the limit as leverage increases, the interest of the debt should converge to the
9
As a curiosity item, the government owned Vattenfall 2-year bonds traded 10bp above the swap rate
in January 2005. Even government owned companies pay a premium.
6
capital cost of the un-leveraged rm, since the ownership of the rm follow a parallel
path, i.e. when the rm is only debt nanced the debt-owner can take it over. Another
potential eect of this convergence is that the , for the bond might converge with the
non-distress , of the stock as distress approaches. The formula (1) below is derived in
a CAPM framework, where 1 [1] is the expected return of investors in equilibrium from
holding the corporate bond, 1
f
is the risk free rate, , is the covariance between the
corporate bond and the stochastic discount factor, and is the market price of risk
10
.
1 [1] = 1
f
+ , (1)
From equation (1) it can be seen that the company , should give a sucient expla-
nation as to why there is a credit spread. Is there a co-variation between the credit risk
and the stochastic discount factor? Are there factors that explain the spreads?
In contrast to the stock market, the repayment obligations are xed in nominal terms,
and given repayment the , against the government bond should be zero. If the market
, diers from zero then the expected post bankruptcy , might inuence its size, or it
is indicative of the bankruptcy event in itself? Can investors ignore the company specic
risk in the valuation of corporate bonds
11
? This gives the two hypotheses that;
2.2 Hypothesis
Claim 1 The interest rate of a corporate bond equal the interest rate of a government
bond, since the specic risk can be diversied.
1
p
1
f
= 0
Claim 2 The dierence between the promised yield and the expected yield is explained by
the failure probability.
1
p
1 [1[: = 0] = 0
c:d 1
p
1 [1[: ,= 0] ,= 0
Where : is the one period default probability.
10
For further details and derivation, see for instance Cochrane (2001).
11
A potentially interesting issue on corporate bond prices (returns) is to see if the data require excessive
risk aversion coecients like in the equity premium puzzle of Mehra and Prescott (1985).
7
2.3 How to do it
The rst step is to formulate the CAPM portfolio in a corporate bond valuation setting
with the added explanatory variable of probability of failure/default. It should be possible
to show how the default probability (:) inuences the theoretical value of the bond port-
folio. It is also interesting to investigate what impact the individual failure probabilities
have with dierent levels of diversication. The second step of the investigation is to test
the model empirically using corporate bond price data
12
for diversication eects (claim
1) and failure probabilities (claim 2). Is there a similar pattern of excess return in bond
prices as in stock prices? Can the probability of failure be proxied by for instance the
credit rating of the companies. Another way of phrasing this question is to ask if the
credit ratings are successful in discriminating the bankruptcy risks. Further it might be
interesting to see if the Fama and French (1992) three factor model has any bearing on a
corporate bond pricing.
In a Generalized Method of Moments
13
(GMM) setting, the tests would amount to
estimating a system of moment conditions
14
:
1
_
_
1
e
i;t
c
i
,
i
,
t
_
1
e
i;t
c
i
,
i
,
t
_
,
t
[1
i;t
1] (1 :
i
) 1
f
+ 1 :
i
_
_
= 0 (2)
where 1
e
i;t
=
_
1
m
t
1
f
t
_
is the excess return of security i at time t, 1
m
t
is the proxy
for the market return, ,
t
a set of factors (here bond returns or perhaps spreads), and :
as before the probability of bankruptcy, but here time invariant. The c
i
parameter is
expected to be zero for all i, since it is not a part of the model but rather the pricing
error. The rst moment condition is that the error term should be zero in expectation, the
second moment condition is the orthogonality of the error terms, and the third condition is
derived by Skogsvik (2005) for business failure prediction purposes
_
1 [1] 1 =
R
f
1+
i
(1
i
)
_
(here restated in gross returns).
Example 3 Parameter estimation
Solving the system (2) amounts to nding the parameter values
^
o that solves the system
for the sample counterpart
_
q
T
_
^
o
_
= 0
_
. Where the hat indicates the sample estimate.
12
Panel data on corporate bond yields are available from the Thomson/Datastream bonds database.
These yields can be transformed to return data.
13
See Hansen (1982) for details. The underlying idea is to nd parameter values that best t the
orthogonality conditions of the econometric model. The major benet of the framework is the exibility
of distributional and functional form assumptions necessary to estimate parameters.
14
The equations should be seen as candidates since the exact test has not been designed yet.
8
Set q
T
_
^
o
_
=
1
T
T

t=1
_

_
1
e
i;t
^ c
i

^
,
i
,
t
_
1
e
i;t
^ c
i

^
,
i
,
t
_
,
t
[1
i;t
1] (1 ^ :
i
) 1
f
^ :
i
_

_
.
^
o =
_
^ c.
^
,. ^ :
_
. and \ a weight-
ing matrix that determines the relative weight of the moment conditions.
Solve the problem min
^

q
T
_
^
o
_
0
\
1
q
T
_
^
o
_
. This corresponds to running the regression
in an OLS-setting.
Since there is an a prior expectation on the c
i
it is reasonable to test this, and this can
be done with the test of Gibbons, Ross and Shanken (1989)
15
. In the suggested system
of moment conditions (2) the number of unknowns and the number of parameters match
exactly, so the system is exactly identied, meaning that there are an equal number of
unknowns and equations.
Example 4 Testing the hypothesis that ,
i
= 0 for all i.
Assume that there is only one security in the sample i = 1 for simplicity. and then
dene o
0
=
_
c
0
,
0
_
the true parameter values. 1 =
_
0 1

the hypothesis. : = 0 the
value to be tested against. and \
1

the covariance matrix. Applying the standard Wald

test method, i.e. under a true H
0
. gives the test statistic;

W
= [1o
0
:] \
1

[1o
0
:]
0
~
2
1
(3)

W
= [,
0
] \
1

[,
0
]
0
~
2
1

W
= ,
2
0
\
1

~
2
1

W
=
^
,
2
\
1

~
2
1
In this example it would perhaps have been simpler to do the t-test, but note that
equation (3) is for all practical purposes the squared t-test.
The strength of the GMM method is that it is easily adapted to include dierent
specications of the model, also non-linear specications, by changing the moment condi-
tions. Assume that the variability of the bond prices can be expected to be inuenced by
15
The test is basically a Wald test with the hypothesis that all
i
= 0. The test statistic is
TNK
N
_
1 +E
T
[f]
0
^

1
E
T
[f]
_
1
^
0

1
^ ~ F
N;TNK
. Where N is the number of observations, T
the number of time periods, K the number of factors, f the same factors as in the system (2),
^
the
standard error matrix, and is the covariance for the cross sectional regression.
9
the prospect of failure, and that this inuence could be discerned in the variance of the
returns, under a hypothesis of , = 0. an extra moment condition can be included;
1 [c: (1
i;t
1) c: ([1
i;t
1] (1 :
i
) 1
f
:
i
)] = 0 (4)
With the extra moment condition (4) the system now have 4N sets of moment condi-
tions (where N is the number of securities) and 3N unknowns (c. ,. :
i
), so the parameters
can be estimated and the system can be tested for over-identifying restrictions
16
. An
unresolved issue is how to separate the test of the claim from the test of the model spec-
ication. This issue will have to be addressed, to avoid the joint hypothesis problem.
The major weakness of the GMM methodology is that the tests lack in strength without
further assumptions. The prospect of using GMM however in this type of setting seems
to be fairly promising.
2.4 Contribution
The rst two contributions are to develop models for 1) the spread between corporate and
government bond prices and 2) the failure probability in a CAPM setting. The second
contribution is to test if the CAPM can explain the pricing behavior on the corporate
bond market, and if the failure/default probability inuence returns.
3 Capital structure trade-o versus historical chance
If the Modigliani-Miller proposition is true, then it does not help to explain why rms
choose their capital structures, since anything goes. However, even with the irrelevance
result it might be possible to observe regularities in companies choices of capital structure
since even by pure chance companies could have the same capital structure. All results
are consistent with the irrelevance proposition and it is thus impossible to reject in an
empirical study, but there might be reasons for companies to cluster in capital structure
choices that do not violate Modigliani and Millers propositions.
Some of the competing theories for explaining capital structure are;
debt capacity,
agency theory,
value irrelevancy,
trade-o theory, and
16
This is the J-test and is a test of model specication, i.e. does the data t the model specication?
10
historical chance.
The debt capacity problem was studied already in the 1960s by Donaldson (1961).
The point is that borrowers can only borrow up to a certain amount when the supply of
credit dries up. The debt-capacity model have done fairly well when combined with the
trade-o theory, as in Baron (1975), Kim (1978), and Bolton and Scharfstein (1990) who
trade-o agency costs of debt against the agency cost of debt. The most actively tested
agency model in the literature is the pecking order theory
17
, named by Myers (1984).
The point of the value irrelevancy propositions of Modigliani and Miller (1958) is that the
total value of a company is independent from the choice of capital structure, i.e. the value
of the assets completely determine the value of the company and the choice of nancing
has no impact at all on the value of the company. The nal two points (the trade-o
theory and the historical chance) are extensively described in the sections below. For a
more extensive treatment, see Harris and Raviv (1991) or a short paper on the themes of
capital structure that is available upon request from the author.
3.1 Capital structure trade-o and results
The idea is: taxation is asymmetric, so the required pre-tax rate of return is higher
for some sources. The tax thus gives dierent sources of nance dierent prices from
the rms perspective. Typically most taxation schemes would favor debt, but all debt
nanced companies dont exist as going concerns for very long. Hence there must be
something that works as counterweight against the tax benets. A theory was developed
where there is a trade-o between the benets and costs of dierent types of nance.
One example is the benets generated by the tax shield and the costs of the increased
risk of bankruptcy. This example is known as "the (static) trade-o hypothesis", and
can be found in Myers (1984)
18
. The problem with this argument is the direct costs of
bankruptcy might be very small, typically legal fees and a small haircut
19
on the assets.
The trade-o theory is the answer to the question why companies arent all debt
nanced. The trade-o theory accepts the benets of debt nance, but argues that there
17
In the pecking-order theory it is assumed that there exists good and bad companies. Both type
wishes to issue securities, and the rst best would be that both rms issue at fair value. However since
the bad rm would rather have the lower nancing cost of the good rm it has incentives to misrepresent
itself as a good rm. The market can thus not separate the two types and will price any security issue
at average fair value. This average price gives the bad rms too cheap nancing and the good rm too
expensive nancing. However, dierent types of securities are more or less sensitive to the rm being good
or bad, they have dierent information sensitiveness. Hence a good rm will use the least information
sensitive nancing rst (internal funds) before they issue securities. A bad rm has no or little internal
funds and is forced to issue securities. This action forces the bad rm to reveal their type to the nancial
markets and thus their obligations are fairly priced.
18
For a more complete treatment, see Kraus and Litzenberger (1973).
19
A haircut is a rebate on the book value, i.e. when a company goes into bankruptcy its net assets are
sold at a lower price than the book value.
11
are also drawbacks from debt nance. The prime example of a drawback is the bankruptcy
risk, and it is argued that as the debt-to-equity ratio increases the risk of bankruptcy
increases. This adjustment process continues until the marginal benets and the marginal
costs equal, resulting in a rm equilibrium.
Tests of the trade-o theory have had mixed results where the big puzzle is the bank-
ruptcy costs. The direct costs of bankruptcy has been measured by Warner (1977), Altman
(1984), and Weiss (1990). The estimates vary between Warners railroads of 2.8% and
Altmans 6% of total value. The estimates of the indirect costs are typically higher but
lack a strong theoretical foundation. Some examples of indirect costs discussed in the
literature are loss of future business, less rm specic investment, suppliers demand cash
payments, and waste of management resources.
As mentioned above Andrade and Kaplan (1998) examines the costs of highly-leveraged
transactions and nd the costs to be less than 10-20 per cent of rm value. The samples
used in these studies are not representative for a general population of rms, so a careful
interpretation is in order. The distinction between liquidation costs and bankruptcy costs
is made in Haugen and Senbet (1978), where the liquidation costs are treated as a sep-
arate capital budgeting problem. In this sense the earlier investigations on costs grossly
overstate the direct costs of bankruptcy. Gilson (1997) extends the cost of bankruptcy
argument by showing in an empirical study that companies that restructured due to eco-
nomic distress tend to have multiple restructurings, and thus the costs are higher than
they appear.
There have also been attempts to nd other costs than the bankruptcy costs, to justify
a trade-o:
If bonds are secured by collateral, then the creditor demand a lower interest since
they are protected in some states of nature. Hence companies can get access to cheap
nance according to Scott Jr. (1977).
The loss in bankruptcy of future tax-credits is used by Brennan and Schwartz (1978),
where the point is that uncertainty about the future cash-ows decreases the value
of the tax-shield. This is supported in the empirical study of Auerbach (1983), who
nds that the U.S. corporate tax distorts both real and nancial decisions.
Graham (2000) calculate the value of the tax benets to about 9.7 % of rm value.
Graham argues in line with an equilibrium hypothesis that the use of tax-shields
avoids losses, since nancing costs are adjusted for the benets of using debt.
Myers (1977) describes the relation between a corporations growth options and its
borrowings. Myers hypothesize that the value of the growth options are inversely related
to the borrowing, i.e. that the presence of the growth options reduces the willingness to
borrow, since the equity owners will choose a sub-optimal investment policy. Further this
sub-optimal investment policy rationalizes the maturity matching that can be observed in
practice. Myers reason on why debt maximizing is not observed in practice, some reasons
12
might be small dierences between personal and corporate taxes, imperfect or incomplete
capital markets, job-security of managers and capital structure as signaling devices.
When there are not only corporate taxes, but also personal taxes Miller (1977) show
that the capital structure is again irrelevant if the total tax-burden is symmetric between
corporation tax and dividend taxation against taxation on bond income. The investor
cannot gain anything by choosing on over the other. The gains function from leverage
G
L
=
_
1
(1
c
)(1
PS
)
(1
PB
)
_
1
L
, is zero if (1 t
PB
) = (1 t
c
) (1 t
PS
), where t
c
is the
corporate tax-rate, t
PS
is the personal tax-rate from stock income, t
PB
is the personal
tax-rate for bond income, and 1
L
is the amount of issued bonds.
The non-debt tax shield is introduced by DeAngelo and Masulis (1980). A non-debt
tax shield is an eect of depreciation deductions or investment tax credits. The empirical
support for the non-debt tax shield is weak, Bradley, Jarell and Kim (1984) cannot nd the
suggested negative relation between the debt and the non-debt tax-shield, and Titman
and Wessels (1988) can not substantiate the non-debt tax shield as a determinant of
capital structure.
If the trade-o theory is a valid description of how companies choose their capital
structure, it might be reasonable that rms use their dividends, repurchase and issue
decisions to converge to the optimal capital structure. Strangely enough Welch (2004)
nds that companies tend to issue equity when prots are high and debt when prots are
low. A similar result can be found in the working paper of Chen and Zhao (2004) where
it is found that a higher market-to-book ratio makes the company persistently more likely
to issue new equity. Chen and Zhao write that the target ratio consideration appears to
be secondary.
Leland (1998) integrates the trade-o theory with the agency theory by examining the
joint determination of capital structure and investment risks, i.e. Leland has a trade-o
model and examines the value of hedging the investment risks in the presence of dierent
agency costs. The benet of hedging is higher when agency costs are lower, i.e. the
hedging benets and the agency costs are aligned. Leland nds agency costs to be 1.37%
of rm value, only about one fth of the tax benets of debt. This nding is conrmed
by the Monte-Carlo simulations of Parrino and Weisbach (1999) who never state the
magnitude.
All in all, the major problem with the trade-o theory is that the empirical studies
cannot give sucient support to the concept of bankruptcy costs as a counterweight to
the taxation gain of the rm. Another puzzling issue is that tests of the trade-o theory
against the pecking-order theory, such as Shyam-Sunder and Myers (1999), Hovakimian,
Opler and Titman (2001) and Fama and French (2002), tend to give more support to the
latter. Frank and Goyal (2003) nd that the support for the trade-o theory in a wider
sense is increasing over time, suggesting behavioral origins. In the survey of Graham and
Harvey (2001) 19% of the responding managers state that their company doesnt have
any target capital structure. There is not equivalence between target capital structure
13
and a trade-o view, but it is not a too big leap of faith to think they are closely related.
There are more explanations for mean-reversion
20
in the capital structure literature;
industries tend to cluster in terms of capital structure choice, as described by Titman
and Wessels (1988). The clustering can be explained by a game of credibility, where a
company with an odd structure must explain the deviation to external parties
21
. Another
explanation is the dependence of nancial and operational policy, since similar structures
might enhance supplier power against clients or client power against suppliers. It might
be a horizontal game. The rm with the odd capital structure will adjust to look more
like its peers in order not to be screened out by its suppliers and clients. This is a possible
rationale for mean reversion in capital structure, not in contradiction to the Modigliani-
Miller propositions, i.e. Modigliani and Miller give a rst order explanation and the mean
reversion hypothesis is a second order explanatory factor.
When the mean reversion is used, there typically is a calibration period, where some
(standard) variables are estimated and then there is an out of sample period where it
is tested if, controlling for the variables, the capital structure approaches the estimated
trade-o ratio. There are two problems with this approach, the rst problem is that the
existence of a static optimal point is assumed and the second problem is that it is assumed
the rms collectively historically have achieved the optimal trade-o ratio. Neither is
necessarily true. In Banerjee, Heshmati and Wihlborg (2000) the determinants important
for the optimal dynamic capital structure are identied, and the speed of adjustment is
measured. The speed of adjustment is interesting since it is important for understanding
the underlying costs and benets that drive the capital choice process.
3.2 Historical chance and results
The choice between equity and debt is not relevant under Modigliani and Millers hypoth-
esizes, the rm can choose any mix and the resulting capital structure is simply the sum of
these (random) choices. There is no special reason as to why a rm has any specic cap-
ital structure. Baker and Wurgler (2002) documents that the eect of market timing in a
rms choice of capital structure is persistent. Even if the rm follows the market-timing
hypothesis and purchases and sells securities when they are cheap or expensive, the
prices are random so the resulting capital structure is again created by random variation.
Hovakimian et al. (2001) have results similar to Fischer, Heinkel and Zechner (1989),
since they have a short term pecking order, but with movement towards a target. Firms
with higher earnings are more likely to issue debt than equity and more likely to repurchase
20
Mean reversion is a process where a series returns to a long-run value after a shock. For example:
y
t
= y

+ (y
t1
y

) +"
t
where y
t
is a time series, and y

is the long-run mean, and "

t
are the shocks.
If (1; 1) then the series will return to y

after a shock.
21
In the nancial sector there is a standard on how to measure the risk adjusted leverage ratio, the
Basel committees capital adequacy directive (CAD). The CAD ratio is an important factor in establishing
professional client and supplier relations, since it is considered to be a simple indication of the credit risk.
14
equity than to retire debt. This is consistent with the rm history hypothesis, but not
with the trade o hypothesis. The result is also consistent with agency theory, since the
owners are unwilling to issue equity when the company realizes good states. Hovakimian
et al. also nd that rms which have had exceptionally good share returns are more likely
to issue equity than other rms and that corporate nancing choices are consistent with
concerns on dilution of eps and book values, a shown by Graham and Harvey (2001).
Further, it seems like capital structure considerations are more important when rm
repurchase rather than when rms raise capital. Kayhan (2004) use the market-to-book
ratio as a proxy in a working paper for the rms investment opportunities. The issue
and repurchase behavior of rms suggest they have target debt ratios, but the cash ows,
investment needs and stock price realizations leads to signicant deviations from the
targets.
In a study of Swedish industrial companies for 1966-1972 Bertmar and Molin (1977)
shows that the increase in the asset base of the companies tends to increase proportionally
with turn-over growth. Companies with lower return on total capital tend to have an
increasing debt-to-equity ratio. The growth in equity was primarily a function of the
return on equity after tax. The companies in the sample had fairly stable dividend
policies, so more protable rms accumulated capital and less protable rms had a
decreasing proportion of equity nancing. If this outcome is representative for longer
time periods, then capital structure of a cross-section of rms would be decided by their
respective historic protability.
The historical chance is another second order explanation. If it doesnt matter which
type of nance is used, then any choice is valid and the resulting capital structure is, in
the limit, simply the sum of random choices.
3.3 Question
Both the trade-o and the historical chance hypotheses have been treated extensively
in the literature. Can these hypotheses be tested? The point is to improve on earlier
attempts to test the hypotheses by introducing a unit-root test, rather then to expand
the theoretical framework.
The irrelevancy hypothesis is consistent with any capital structure choice. Hence,
one empirical consequence of the irrelevancy hypothesis is that it does not matter which
type of capital is chosen. A random choice of capital is consistent with the irrelevancy
hypothesis. This is the rst empirical consequence to test.
The trade-o hypothesis is typically modeled by a mean-reversion. The idea is that
there exists a long run optimal choice, and that rms tend to try to change their capital
structures to reect this long run optimum. Note that the mean-reversion consequence is
complementary to the random choice, so the mean-reversion can be rejected in favor of
the random choice but not the other way around. The mean-reversion assumes an optimal
trade-o and that choices are not random but based on achieving the optimal trade o.
15
3.4 Hypotheses
Claim 5 The capital structure choice is random.
_
1
1
_
t
=
_
1
1
_
t1
+
t
Claim 6 The capital structure choice is mean-reverting. The * denotes the optimal
capital structure.
_
1
1
_
t
=
_
1
1
_

+ ,
__
1
1
_
t1

_
1
1
_

_
+
t
. , (1. 1)
3.5 How to do it
The idea is not to develop or extend any theoretical framework, both the irrelevance and
trade-o theories has been around for a long time, but to test empirically which is the
more credible description.
D/E
x Random and mean-reversion
Random
Random
Neither
Neither
Time
Accept
Figure 2. Testing for randomness in capital structure.
16
In gure two, the basic test for randomness and mean-reversion is shown. If the capital
structure moves from point X in a stochastic fashion, it could be expected to be within
the (outer) cone, and we cannot reject the null of randomness. If however for some reason
the process ends up within the cone, the null cannot be rejected.
The major weakness of the test is the strength. The capital structure is likely to
remain at the same level most of the time and only when there are very large changes
can the test show any strength. An obvious remedy to the power problem is to increase
the data set, either through a long time series, a large cross section, or both. It should
be fairly un-problematic to use panel data, since it can be expected that either all or no
rms have any specic process.
If at all possible, a test between mean-reversion and randomness will be developed.
The types of test that are likely to be fruitful are unit root tests, or hedging error
22
on
the debt-to-equity relation. Swedish accounting data have been acquired for the period
of 1990 to 2004. More data is available in Thomson/Datastream.
3.6 Contribution
Mean-reversion has been extensively used as an empirical consequence of the trade-o
theory. The suggested contribution here is to test the hypothesis of mean-reversion in
capital structure against that the result is pure chance. Strebulaev (2003) has shown
that a dynamic trade-o model can generate mean reverting data. Testing the trade-o
model against historical chance has not been done in any previous study. The closest
test was done by Castanias (1983) who tested the irrelevance against the trade-o in a
cross-section. The research question is empirical in nature, so a statistical test must be
designed and applied.
4 Trade credits
The unit of measurement in capital structure choice theory is the rm, but it is not the
only possibility. Consider a tight chain of three companies where rm one sells to rm
two and rm two sells to rm three. The choice of capital and thus bankruptcy risk of
rm two might have an impact on both rm one and rm three. The interdependence
between rms and the supplier/client strengths in terms of bargaining power might have
an impact on the capital structure.
Example 7 One simple example is a railroad company operating a route from a mine.
The owners of the railroad will want the mine to survive and is thus exible in pricing
22
Both classes of tests have been explored by Andersson (2003).
17
policy. The mine anticipates this and in a sense will be using the railroads capital in its
capital structure and risk decision.
The companies in isolation might be too simple a unit of analysis, and perhaps a
vertical analysis is desirable. Supposing there are less than perfect product markets, the
rst supplier can use a failure (success) in the nancial policy to adjust the operating
policy, so the policies of the rst supplier have an impact on the second supplier. The
hypothesis is that not only are nancial policy and operating policy of a rm dependent
on each other, but they are also dependent on the policies of other rms. If this hypothesis
is correct then it would be a too strong a simplication to only consider one company in
isolation.
To make the vertical analysis operational some choice must be made in terms of com-
plexity and one option is to focus on trade credits. A recent advance in explaining trade
credits by Burkart and Ellingsen (2004) is based on the propensity of the entrepreneur to
divert funds that were acquired to nance investment (with an eciency loss in transform-
ing goods to cash). Even if this type of behavior is a real aspect of human behavior, it is
not that common to observe entrepreneurs running o with the credits or goods they have
received from a supplier or nancier. Perhaps there are other reasons for the existence
of trade credits? The paradox described in the literature is that there exist trade credits
even in the presence of (well functioning) nancial markets. Why dont the nancial inter-
mediaries nance the transaction between the supplier and the entrepreneur? Typically
it is assumed that the nancial intermediaries have advantages of scale in monitoring and
expertise in giving credits the supplier typically cannot be expected to have or maintain.
Firm 1 Firm 2
Financial policy Financial policy
Trade Credits
Financial Intermediary
Figure 3. The choice of trade credits by the supplier and the client.
If the nancial intermediaries demand non-competitive prices due to poor competition
or inecient monitoring costs, there is an incentive for the supplier and entrepreneur
18
to collaborate. If the supplier and entrepreneur have ongoing business and prices on
nancial services are less then competitive, then the supplier and the entrepreneur can
protably exclude the bank. One empirical consequence of the collaboration hypothesis
is that rms that collaborate are more protable. Another special property of trade
credits is mentioned by Scott Jr. (1977), the suppliers dont have much protection (debt
covenants) as it would be expensive to re-negotiate for each transaction, hence if there is
any uncertainty about repayment the trade credits should dry up very quickly.
In a survey of agency research and capital structure Harris and Raviv (1991) identify
four sub-categories for the determinants of capital structure;
ameliorate conicts of interest between various groups with claims to the rms
resources, including managers,
convey private information to capital markets or to mitigate adverse selection eects,
inuence the nature of products or competition in the product/input market, or
aect the outcome of corporate control contests.
The agency theory approach for explaining the choice of nancial policy was proposed
by Jensen and Meckling (1976). In the paper, the authors argue that one reason for
the importance of the nancing decision is that the current owners and future owners
or lenders have dierent information sets, and there is an information asymmetry. Hart
and Moore (1995) continue on the same line of argument and extend the results with
hard claims as an instrument to restrain management. Hart and Moore conclude that
the seniority of nance sources can be used to optimize rm value. The agency approach
was an additional response to the irrelevance theory, and concerns the behavior of the
agent against the principal. There are numerous set-ups that have been examined, such
as owner-manager, owner-board, large owner-small owners, etc. The interaction between
capital structure and top management compensation is studied by John and John (1993).
The point being that the capital structure and compensation are jointly determined and
that this joint determination has an impact on the optimal solution. It is now only for all
equity rms that the strict alignment of management is desirable. The agency approach
includes the possibility to increase value by changing capital structure, and thus it spurred
invention of take-over theories. The focus in the take-over theories is on how to exploit
erroneous capital structures. If a company has too much equity, it is protable to do a
leveraged buy out etc. Miller (1991) argue that the leveraged buy-outs in the 80s achieved
substantial eciency gains by re-concentrating corporate control and redeploying assets.
For the capital structure literature the take-over discussion is marginal, and probably
the largest impact of the take-over discussion is that it introduces a credible threat to
inecient rms. However the threat can also be something else, such as expensive credits.
The existence of trade credits might be the best response to the long-run threat of an
inecient credit market.
19
There are more aspects and explanations of trade credits, such as size of the companies
involved, where larger well known companies have easier access to trade credits. Another
possibility is the non-optimal behavior of suppliers, where the supplier could avoid at zero
cost giving a trade-credit, but does not.
4.1 Question
In the theory of trade credits, it has normally been assumed a perfect nancial market,
albeit with asymmetric information. If the competition between the nancial intermedi-
aries is not perfect, then the rm that uses the services will have to give up part of the
wealth created, or intended to be created, in the transaction to the nancial intermediary.
If the competition between nancial intermediaries is not perfect then there is a rational
basis for the existence of trade credits, even though the existence would typically seem to
be an ineective solution. The suggested question is thus if the cost of external credits
can explain the existence of trade credits
23
?
4.2 Hypothesis
Claim 8 Non competitive credit costs and collusion cause the existence of trade credits.
4.3 How to do it
The recipe for the trade credits investigation is not well developed, but the likely path
is to rst develop the theory into a mathematical framework. Typically the frameworks
within the agency framework are in the form of linear programming set-ups. The model
will probably be based on an exogenous sales price and xed production costs for the
industrial parties, and focus on the division of the surplus created in the transaction, in
line with standard game theory. For the second phase, the statistical tests are standard.
If adequate data material is not available, it should be possible to survey companies that
extend trade credits.
4.4 Contribution
The idea that transaction or credit costs can generate trade credits is an extension on
previous theoretical results. Previous studies have primarily focused on 1) the credit risk
of the seller, and argued that a nancial intermediary is an expert on management of
credit risks, 2) the asymmetric information about payment, 3) quality of goods or 4)
perks derived from the goods. The contribution of this study is to nd out if collusion
23
The shape of the cost function for a supplier that extends trade-credits is probably a key aspect in
investigating. There are several dierent options available, the supplier might risk anything from a small
share of his capital or prots to the survival of the company.
20
between the supplier and entrepreneur improves their outcome and if they are better o
in internalizing the cash ows. The hypothesis will be tested in the empirical part of the
study.
5 Over all contribution
This study will contribute to the academic elds of nancial accounting and corporate
nance, by deepening the knowledge in the previously identied area of nancial policy
choice. The study will contribute to and perhaps validate the theoretical knowledge of the
nancial policy choice. From a practical aspect the study will yield models on nancial
policy, which can be applied by practitioners, i.e. boards of directors, CFOs and nancial
controllers for capital budgeting purposes. With the models prediction on feasible or
desirable capital structures could be made.
The objective of the proposed study is to learn more about how capital structure
choices are made. Three main questions will be addressed; how are corporate bonds
priced, can historic chance and/or mean-reversion in capital structure explain capital
structure choices, and is the rm a relevant unit of measure for capital structure research.
The study will be investigative, and the result can hopefully be useful for prediction
purposes. No normative statements will be made in the study, unless there are violations
of fundamental principles, such as the law of one price.
As an important part of testing the model/hypothesis it has to be translated into
variables that are observable. The natural choice for an investigation on the choice of
nancial policy is to use market data and nancial accounting parameters. The result
from the project on corporate bond pricing can perhaps, with regards to the bankruptcy
issue, be related to the research eld of bankruptcy prediction.
The proposed study is relevant, since the contribution could increase our understanding
of why and how companies choose to capitalize like they do and give some insights into
the eects of the choices.
6 Delimitations
Companies in samples should be exposed to the scrutiny of both product and nancial
markets. A single group company is typically not exposed to the judgment of the nancial
market and is thus excluded. Even if the samples are not an important point of the
projects, Swedish data will be used if it is available.
There might be macro implications and dependencies in the choice of capital, such as
exposure to similar macro risks. The macro issues will largely be ignored. In a sense the
analysis will thus be partial.
21
7 Time schedule
The ambition is to nish the three studies at the beginning of 2007. To achieve this
deadline, each paper or study has to be completed in ve to six months, so the time
schedule is:
Paper one: March 2006
Paper two: August 2006
Paper three: January 2007
Cover February 2007
8 Endnote
Most of this proposal was written more than a year ago. I have extended the deadlines
by a few months and made some minor changes in the text. The current status of the
projects are that there is a version of the rst paper, that is largely in line with the
proposal. I have started on the second paper and have written a story and about the
empirical strategy. As a working hypothesis I want to extend the study to include a test
against the pecking order hypothesis. The reason I want to extend the paper is that the
pecking order hypothesis and the historical chance hypothesis have quite a few similar
predictions. I am currently working with the data material for the second study.
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