Testing static tradeoff against pecking order models

of capital structure

Introduction●The theory of capital structure has been dominated by the search for optimal capital structure.

●Optimums normally require a tradeoff

●A value-maximizing firm would equate benefit and cost at the margin, and operate at the top of the curve

Static tradeoff theory●權衡理論是同時權衡考量舉債所帶來的優點 ( 即稅盾 ) 與缺點 ( 破產成本 ) ，並認為公司會有最佳的資本結構●Predicts that each firm adjusts gradually toward an optimal debt ratio●The statistical power of some usual tests of the tradeoff model is virtually nil●It predicts reversion of the actual debt ratio towards a target or optimum●It predicts a cross-sectional relation between average debt ratios and asset risk, profitability, tax status and asset type

Two problems●None of the empirical literatures have systematically compared the explanatory power of their fitted equations with alternative explanations of financing behavior●None has checked whether their equations could seem to work even when actual financing is driven by other forces. That is, they have not checked the statistical power of their tests against alternative hypotheses●We propose an alternative time-series hypothesis based on the pecking order theory of optimal capital structure

Pecking order theory●The pecking order is one implication of the Myers-Majluf (1984) analysis of how asymmetric information affects investment and financing decisions

●First, if costs of financial distress are ignored, the firm will finance real investment by issuing the safest security it can

●Here “safe” means “not affected by revelation of managers’ inside information”. In practice, this means that firms which can issue investment-grade debt will do so rather than issue equity

●Second, if costs of financial distress are serious, the firm will consider issuing equity to finance real investment or pay down debt

●It may forgo the issue if managers’ information is sufficiently favorable and the issue price is too low

●In that case, the debt ratio will remain uncomfortably high or real investment will be curtailed. However, less optimistic managers will issue equity

Pecking order theory●There is no well-defined optimal debt ratio, the debt ratio is just the cumulative result of hierarchical financing over time●The attraction of interest tax shields and the threat of financial distress are assumed second-order●Highly profitable firms with limited investment opportunities work down to low debt ratios●Firms whose investment opportunities outrun internally generated funds borrow more and more●Changes in debt ratios are driven by the need for external funds, not by any attempt to reach an optimal capital structure

Pecking order theory●由於公司經理人與外部投資人存在信息不對稱的現象，使得公司在進行融資決策時，偏好優先使用交易成本最小的資金來源● 企業最優先的融資偏好是內部資金 (包括保留盈餘與折舊 )，這是因為內部資金沒有任何發行成本，也不須揭露企業的財務資訊●當內部融資耗盡後，公司才會使用外部資金，而使用外部資金的優先順序依序為負債、可轉換證券、特別股，以及普通股。

What we find?●The pecking order model has much greater time-series explanatory power than a static tradeoff model●The pecking order hypothesis can be rejected if actual financing follows the target-adjustment specification. On the other hand, this specification of the static tradeoff hypothesis will appear to work when financing follows the pecking order●This false positive results from time patterns of capital expenditures and operating income, which create mean-reverting debt ratios even under the pecking order●Thus we have power to reject the pecking order but not the static tradeoff specification

Two contributions●The first is methodological, that is our procedures for testing the statistical power of alternative hypotheses about financing behavior●The second is empirical, based on the excellent performance of a simple, time-series pecking order model, at least for our sample of mature, public companies, and the weak performance of target-adjustment models derived from the static tradeoff theory

The funds flow deficit(1)

The pecking order hypothesis to be tested

(2)

A target adjustment model

● is the target debt level for firm i at time t●One common response starts with the historical mean of the debt ratio for each firm, which can be multiplied by total capital to obtain an estimated target debt level●Jalilvand and Harris (1984) report that use of a three-year moving average does not alter their results●The hypothesis to be tested is bTA>0, indicating adjustment towards the target, but also bTA <1, implying positive adjustment costs

(3)

Data & sample●All firms on Industrial Copustat files.( 排除管制公用事業與金融公司 )flow of funds statement from 1971Sample period 1971-1989.157 firms

帳面負債比率=長期負債 /資產帳面

價 值。資產帳面價值包括淨流動資金。資產回報率=稅後經營收益 /資產帳 面價值

整個抽樣期間的平均負債率 =0.18

The targets are based on sample mean debt ratios (0.18) for each firmBpo=0.85,, the pecking order does very well.The pecking order results show that external funding is dominated by debt.

The pecking order hypothrsis did less well in last half of the 1980s. Several of the low for 1971-1989 are for firms which undertook leveraged restructurings in late 1980s

1971-1989年ㄧ些低的是 20世紀 80年代後期進行槓桿重組的公司

The story so far●A simple target-adjustment model provides some explanatory power for changes in debt ratios, and its coefficients look reasonable and are statistically significant.●A simple pecking order model has much better explanatory power.

Power●The target-adjustment model can generate plausible and highly”significant”statistical results even when it is false.●The simple pecking order test does not suffer from lack of power.It is correctly rejected when it is false.

Method●Statistical power is often investigated using Monte Carlo simulation on hypothetical data.●Generating hypothetical time series of debt issues or retirements, one series for each of the 157 sample companies, using either the target adjustment model,or the pecking order model.

Generating the financing time series

Pecking order Using actual data for operating cash flow.

The firm is assumed to issue debt if the deficit is positive and retire debt if it is negative.

Target-adjustment model,with target set at historical average It again started with the 1971 year-end value of the book debt ratio. Ratios for later years were simulated according to the basic target adjustment model.

The static tradeoff theory doesn’t require any particular numerical value for the adjustment coefficient bTA.

Target-adjustment model,with target determined by firm characteristics●Static tradeoff models maintain that a firm’s optimal debt ratio is a function of risk, asset type, tax status and profitability.

●The simulated debt ratio series were 　generated by using the 1971 value of the 　 book debt ratio of each firm as the seed value.

●(It believe these coefficients are plausible, but they were not matched to any particular empirical study.)

●Data : 157 firms from 1971 to 1989.●Panel A :●Panel B :●Panel C :●Panel C added an error term.

The fitted models

Table 4

●The results so far strongly increase our conÞdence in the pecking order against the target-adjustment model, at least for our sample of mature public companies.●This underscores our theme that tests of the traditional theories of capital structure against a zero null are not persuasive evidence.

A comment on cross sectional test

Table 5

Conclusions●對於成熟企業的樣本，融資順位是一個良好的ㄧ階描述企業融資行為。●簡單的目標調整模型，當獨力測試時，表現良好。●當兩個模型聯合測試時，融資順位的系數和意義幾乎不變。●融資順位的強勁表現不會發生，是因為公司在短期內為未預期的現金需求提供債務，研究結果顯示，企業計畫用債務融資預期赤字。●我們模擬實驗表明，即使假設，目標調整模型也不會拒絕。●研究結果顯示，融資順位中比在目標調整中有更大的依從性。