Paper Review \" Do Firms Rebalance Their Capital Structures? \"

Paper Review “Do Firms Rebalance Their Capital Structures?” By MARK T. LEARY and MICHAEL R. ROBERTS

Brief Introduction to the Capital Structure Theory Under Modigliani and Miller’s assumptions (1958), the capital structure of a firm seem to have no relevance since changes on firm’s capital structure do not create value. However, once the perfect market hypothesis is relaxed, the literature has come up with two main theories on capital structure: • •

Trade-off Theory Pecking order Theory

Allows Bankruptcy costs to exist Capture the costs of Asymmetric Information

According to the Trade-off theory there exist an optimal level (or range) of capital structure. The Pecking order Theory, instead, assets that companies finds more convenient to prioritize their sources of financing (first they use internal financing, then debt as a second choice, and equity if the previous two options are not available). More recently, has spread the “Market Timing” hypothesis. According to this theory companies resort to the most convenient form of financing in a specified moment (based on preferences of “irrational” investors).

Main Results Leary and Roberts perform an empirical analysis to understand whether or not firms engage in a dynamic rebalancing of their capital structures in the presence of adjustment costs. The most important result of their analysis is that, if adjustment costs are considered, firms try to return (even if slowly sometimes) their capital structure towards some optimal level (or long term average), which is in contrast with the previous literature. Using their words: “Our nonparametric and duration analysis show that the effect of equity issuances on firms' leverage is erased within two years by debt issuances. Similarly, the effect of large positive (negative) equity shocks on leverage is erased within the two to four years subsequent to the shock by debt issuances (retirements).”

They also show that, contrary to the previous literature, the persistency effect of shocks on leverage is more likely due to these adjustment costs rather than the firm’s indifference towards their capital structure. In particular, they refer to the Baker and Wurgler (2002) market timing variable on leverage, that is, the External Finance-Weighted Average (EFWA), and they show that it attenuates significantly when adjustment costs decline. From that, they conclude that the adjustment costs are the key variable which determines the speed at which firms respond to leverage shocks.

Related Literature Recent empirical evidence question whether firms try to keep their debt ratios at some target level. Fama and French (2002) for example, assert that those debt ratios adjust slowly toward their targets. Baker and Wurgler (2002) find that that historical efforts to time equity issuances with high market valuations have a persistent impact on corporate capital structures and conclude that capital structures are the cumulative outcome of historical market timing efforts, rather than the result of a dynamic optimizing strategy. Welch (2004) finds that equity price shocks have a persistent effect on corporate capital structures as well and conclude that stock returns are the primary cause of capital structure changes and that corporate motives for net issuing activity are unknown. All these findings share the following common idea: Shocks to corporate capital structures have a persistent effect on leverage, which the last two studies interpret as evidence against firms rebalancing their capital structures toward an optimum. However, these empirical tests do not consider the adjustment costs related to this dynamic rebalance of the capital structure. They simply assume that this rebalancing is costless (or that the cost function is convex). Marginal Contribution

The first paper that introduce the presence of Adjustment Costs.

In the presence of those costs, it may be not always optimal to respond immediately to capital structure shocks. In fact, if the adjustment costs exceed the benefits, firms will wait to recapitalize.

Further Results Leary and Roberts also point out that firms are often inactive with respect to their financial policy, but when they decide to issue or repurchase debt and equity, they do so in clusters (on average, once a year). Notice that the resulting size and frequency of external financings depends on the structure of the adjustment cost function (i.e. the fixed cost, proportional cost and fixed cost + weakly convex cost component scenarios).

Then, they find that firms are significantly more likely to increase leverage if their leverage is relatively low, if their leverage has been decreasing, or if they have recently decreased their leverage through past financing decisions. Finally, they show that their dynamic rebalancing result (towards a specific range, not level) is consistent with previous empirical work that finds mean reversion in leverage using partial adjustment models which, in turn, imply that shocks to leverage have persistent effects despite active rebalancing. More specifically, they perform a duration analysis in which they introduce the hazard function in order to specify the instantaneous rate at which a firm adjusts its capital structure conditional on not having done so for a specified length of time (they reformulate the problem in terms of probabilities). Then, they point out the relation between this hazard function and the adjustment costs and they assert that ‘the general level of the hazard curve reflects the overall frequency of adjustments: the higher the level, the more frequently adjustments occur’.

Dataset ‘The data are taken from the combined quarterly research, full coverage, and industrial COMPUSTAT files for the years 1984 to 2001’. They have also used return data from the Center for Research in Security Prices (CRSP) and they have removed from the sample all regulated and financial firms ‘to avoid financial policy governed by regulatory requirements and maintain consistency with earlier studies’. Then, since the emphasis of this study is on dynamic capital structure, they have considered only firms with at least four years of contiguous observations. ‘The final data set is an unbalanced panel containing 127,308 firmquarter observations: 3,494 firms each with a time series of observations ranging in length from 16 to 71 quarters’.

Conclusion As Leary and Robert argue, their rebalancing evidence is consistent with elements of both the dynamic tradeoff model and the modified pecking order. Their finding of a significant response to both low or decreasing leverage and high or increasing leverage is coherent with the existence of a target range for leverage, as the dynamic tradeoff model postulate. However, the asymmetric behavior of this effect is also consistent with the dynamic pecking order's theory, according to which firms are more concerned about excessively high leverage rather than excessively low leverage. These results imply that both the bankruptcy costs associated with debt financing and the information asymmetry costs associated with equity financing are important determinants of capital structure decisions. The persistent effect of shocks on leverage documented by previous studies (heavily supported by Baker and Wurgler (2002) and Welch (2004)) is therefore more likely due to optimizing behavior in the presence of adjustment costs, which actually play a key-role in such analysis and cannot be omitted, rather than firms’ indifference toward the capital structure. Alessandro Avoli