Capital Structure and Firm Characteristics
Firms that seemed to be underlevered shared common characteris-tics.12 Underlevered firms were typically larger, more mature, and more profitable than those that were not. They also had large intangible assets, greater growth opportunities, and higher earnings volatility. Blouin et al. suggested that these firms may also have other immeasurable characteristics that explain the apparent underleverage, including higher agency costs than otherwise comparable firms.13 Agency costs can reflect a tendency for managers to engage in risky projects or to reject potentially profitable projects as debt increases in the capital structure.
Kayhan and Titman examined whether a firm's capital structure is driven more by its history or by a target capital structure.14 They found that variables such as past profitability, financial deficits, past stock returns, market timing, leverage deficit, and change in target capital structure will at times cause capital structure to deviate significantly from targets, and that these deviations can be long-standing. The reason for these deviations persisting may be that the transaction costs associated with adjusting the capital structure are large relative to the perceived cost of a suboptimal capital structure. Financial deficits and past stock returns had the greatest and most enduring impact on capital structure. These variables continue to affect capital structure over a 10-year period. However, although the influence of financial deficits is partially reversed over a five-year period, the impact of past stock returns is not. The latter may indicate a change in target capital structure if the stock price increase is due to increased growth opportunities. Although these effects persist, firms still tend to behave as though they have target debt ratios, and act to move slowly back to their target capital structure.
Capital Structure Policy, Business Cycles, and Macroeconomic Conditions
Trade-off theories suggest that the choice of capital structure is based on achieving a balance between tax benefits and the costs of bankruptcy. The value of the tax benefit depends on the cash flows of the firm, which in turn depend on the business cycle. This suggests that there should be a relationship between capital structure and macroeconomic conditions. Trade-off theories suggest that when cash flows are high, firms should issue more debt to take advantage of the tax shield. Furthermore, when bankruptcy costs are low, firms can afford to bear more debt. Trade-off theories would thus suggest that debt should be higher during expansions because cash flows are higher and bankruptcy is less likely. An empirical relationship between business cycles and capital structure has indeed been observed. However, the relationship is not what trade-off theory would predict.
Korajczyk and Levy examined how firm-specific traits and macroeconomic conditions play a role in the capital structure decision.15 Their research supports components of both the trade-off and pecking-order theories. Trade-off theory states that firms balance the tax benefit of debt against bankruptcy costs. The more a firm can benefit from the tax shield (firms that are profitable and have high tax rates) and the lower the cost of bankruptcy (firms that have a high credit rating and substantial collateral), the more debt they will be able to assume. The findings were consistent with this. Firms with large tangible assets had relatively more debt (large tangible assets serve as collateral and therefore decrease bankruptcy costs) than firms with unique or intangible assets that tended to have less debt.
The authors added another dimension to the analysis by dividing firms into two categories: constrained and unconstrained. Constrained firms were those with inadequate internal funding and that faced high information costs in external markets. Unconstrained firms were those with adequate internal funds. High information costs arise from information asymmetries whereby the market may be uncertain about a firm's prospects, although management, with access to all the information, sees a promising future. Findings showed a significant difference in choices of capital structure between constrained and unconstrained firms. Target leverage is procyclical for constrained firms and countercyclical for unconstrained firms. In other words, constrained firms were more leveraged in times of expansion and less leveraged during downturns. In contrast, unconstrained firms were less leveraged during expansions and more leveraged during downturns. Whereas the findings for constrained firms are consistent with trade-off theories, the findings for unconstrained firms are not. Instead, they are consistent with pecking-order theory that would suggest that during an expansion, when there is greater availability of internal funding, firms can avoid external financing. Overall, the authors found that the capital structure of unconstrained firms was closely related to the macroeconomic environment, but that of constrained firms was driven largely by deviations from target capital structure. It seems that constrained firms do not have the luxury of timing the market, and that the choice to issue more debt is not a choice at all, but firms take what they can get. Finally, it seems that the pecking-order theory works well for unconstrained firms, whereas constrained firms tend to behave as though they have a target capital structure.
Hackbarth, Miao, and Morellec also explored the relationship between capital structure and macroeconomic conditions and found that leverage is countercyclical, a firm's debt structure being 40 percent larger during booms than during periods of contraction.16 In a related paper, Chen explained that the capital structure decision has more to do with business cycles and macroeconomic conditions than trade-off theories suggest.17 By modeling firms' behavior under various economic conditions, he found that the capital structure of firms that are more sensitive to systematic (market) risk should be countercyclical. The explanation for this is that cash flows and required returns will be very sensitive to macroeconomic conditions. Chen also related the expected growth rate and volatility of cash flows to the likelihood of default and management's decision to issue debt. He found that low expected growth rates cause a firm to wait to issue additional debt and lead a firm to default sooner.