Two Common Problems in Capital Structure Research: The Financial-Debt-To-Asset Ratio and Issuing Activity Versus Leverage Changes
Ivo Welch(Brown University)

This paper points out two common problems in capital structure research. First, although it is not clear whether non-financial liabilities should be considered debt, they should never be considered as equity. Yet, the common financial-debt-to-asset ratio (FD/AT) measure of leverage commits this mistake. Thus, research on increases in FD/AT explains, at least in part, decreases in non-financial liabilities. Future research should avoid FD/AT altogether. The paper also quantifies the components of the balance sheet of large publicly traded corporations and discusses the role of cash in measuring leverage ratios. Second, equity-issuing activity should not be viewed as equivalent to capital structure changes. Empirically, the correlation between the two is weak. The capital structure and capital issuing literature are distinct.

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Monte Carlo Simulations and Capital Structure Research*
Xin Chang(Nanyang Business School, Nanyang Technological University)
Sudipto Dasgupta(Department of Finance, Hong Kong University of Science and Technology)

The evolution of the debt ratio under alternative types of managerial behavior can generate non-standard leverage processes. This creates problems for statistical inference in empirical capital structure research. We argue in this paper that when the data generating process is not standard, a useful way to evaluate the appropriateness of inferences and the empirical methodology is via Monte Carlo simulations that mimic the data generating process under alternative assumptions about managerial behavior. We illustrate with several examples.

*We are grateful to a number of individuals for comments on our earlier working papers, from which some of this material is drawn. We thank Heitor Almeida, Malcolm Baker, Sugato Bhattacharyya, Christine Brown, Murillo Campello, Howard Chan, Eric Chang, Long Chen, Kevin Davis, Doug Foster, Murray Frank, Fangjian Fu, John Graham, Bruce Grundy, Campbell Harvey, Gilles Hilary, Armen Hovakimian, Nengjiu Ju, Ayla Kayhan, Laura Liu, Peter MacKay, Salih Neftci, Douglas Rolph, Nilanjan Sen, Lewis Tam, Sheridan Titman, Ivo Welch, Mungo Wilson, Xueping Wu, and especially Michael Lemmon (AFA 2007 discussant), Jie Gan, Vidhan Goyal, and Michael Roberts. We also thank seminar participants at the 11th Finsia–Melbourne Centre Banking and Finance Conference, 2007 American Finance Association meetings, Arizona State University, Chinese University of Hong Kong, City University of Hong Kong, Hong Kong Baptist University, University of Macau, Hong Kong University of Science and Technology, Nanyang Technological University, National University of Singapore, Singapore Management University, University of Hong Kong, University of New South Wales Research Camp 2006, and University of Southern California. Chang acknowledges financial support from Academic Research Fund Tier 1 provided by Ministry of Education (Singapore) under grant numbers SUG FY08, M58010006. Dasgupta acknowledges financial support from Hong Kong’s Research Grants Council under grant # HKUST6451/05H.

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Optimal Expansion Financing and Prior Financial Structure*
Sucipto Sarkar(McMaster University)

This paper identifies jointly the optimal investment trigger and the optimal financing package for a corporate expansion project, using a real-option ‘trade-off’ model with agency problems. It also identifies the optimal initial capital structure of the firm (before the expansion). We show that it is generally optimal to use more debt than equity to finance the expansion. The other results are as follows: (i) existing debt has a negative effect, while the debt component of expansion financing has a positive effect, on investment; (ii) the debt component of the optimal expansion financing package is a decreasing function of the pre-expansion leverage ratio (consistent with mean reverting leverage ratios), and is also decreasing in the magnitude of the expansion opportunity; and (iii) the optimal pre-expansion leverage ratio is a decreasing function of both the firm’s profitability and the magnitude of the growth opportunity. These relationships are generally consistent with empirical evidence, and help reconcile the trade-off theory of capital structure with apparently contradictory empirical evidence.

*I would like to acknowledge financial support from the Social Science and Humanities Research Council of Canada.

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The Detection and Dynamics of Financial Distress*
Julie Fitzpatrick(Department of Business Administration, SUNY)
Joseph P. Ogden(School of Management, University at Buffalo SUNY)

Using samples of US firms, we examine the efficacy of six risk-proxy variables to forecast 5-year failure: year-end t-values of stock return volatility, firm size, recent profitability, market leverage (LEV), book-to-market equity ratio (BM), and recent stock return. Logistic regression results indicate that firm size is most powerful, while LEV and BM are weakest. We then identify distressed firms and analyze the effect of year t+1 operating and financing cash flows on 5-year failure rates for these firms using a new methodology, failure risk surprise. Results explain why LEV and BM are weak forecasters of 5-year failure rates: Low-LEV and low-BM (high-LEV and high-BM) distressed firms are less (more) likely to have a profit in year t+1, and are also more likely to issue equity (retire debt) in year t+1, interactions which tend to moderate failure risk. We also find that failure risk sensitivity to year t+1 operating result increases with both LEV and BM, while failure risk sensitivity to future macroeconomic conditions is significant only for high-LEV firms. Many results are consistent with the tradeoff theory of capital structure, while other results indicate that managers make financing decisions to take advantage of mispricing.

*Earlier drafts of this paper were presented at the 2005 Financial Management Association meeting and the 2007 Southwest Finance Association meeting. The authors wish to thank Jingzhi (Jay) Huang, Kenneth Kim, Philip Perry, Samuel Tiras, Susan Lewis, Naohisa Goto, and especially an anonymous IRF referee and Editor Sudipto Dasgupta for helpful comments.

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Information Asymmetry and Financing Decisions*
Wolfgang Bessler(Center for Finance and Banking, Justus-Liebig-University Giessen)
Wolfgang Drobetz(Institute of Finance, University of Hamburg)
Matthias C. Gr?ninger(Department of Corporate Finance, University of Basel)

This study conducts tests of the pecking order theory using an international sample with more than 6000 firms over the period from 1995 to 2005. The high correlation between net equity issuances and the financing deficit discredits the static pecking order theory. Rather than analyzing the predictions of the theory, we test its core assumption that information asymmetry is an important determinant of capital structure decisions. Our empirical results support the dynamic pecking order theory and its two testable implications. First, the probability of issuing equity increases with less pronounced firm-level information asymmetry. Second, firms exploit windows of opportunity by making relatively larger equity issuances and build up cash reserves (slack) after declines in firm-level information asymmetry. Firms from common law countries use parts of their proceeds from an equity issuance to redeem debt and to rebalance their capital structure. These findings are consistent with a time-varying adverse selection explanation of firms’ financing decisions.

*We thank an anonymous referee, Daniel Höchle, Dusan Isakov, Iwan Meier, Vefa Tarhan, Heinz Zimmermann, Sudipto Dasgupta (the editor) as well as participants at the 2009 Midwest Finance Association (MFA) Meeting in Chicago, the 2009 European Financial Management Association (EFMA) Meeting in Milan, the 2009 Northern Finance Association (NFA) Meeting in Niagara-on-the-Lake, and the 2009 Financial Management Association (FMA) Meeting in Reno for comments.

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