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Security issuance decisions, idiosyncratic risk, and macroeconomic dynamics

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Abstract

This paper, using a large panel of UK manufacturing firms, empirically examines firms’ financing decisions under risk. The results reveal that while idiosyncratic risk affects changes in debt negatively, it affects both the issuance of new equity and the use of retained earnings positively. The results also suggest that in periods of high macroeconomic risk, the use of new debt, equity financing, and retained earnings declines. Finally, the analysis provides evidence that both types of risk also have a significant and negative influence on changes in firms’ target leverage.

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Notes

  1. Titman and Wessels (1988) and MacKie-Mason (1990) are among the early studies that have examined the impact of idiosyncratic risk on leverage.

  2. However, we should note that prior studies estimating the effect of risk have largely focused on relating the target leverage to risk. Rather, the focus of this paper is to examine how risk affects changes in leverage and the components of changes in leverage (security issuance decisions).

  3. As the paper allows both entry and exit in the sample, it mitigates sample selection and survivor bias.

  4. This restriction is imposed because at least four observations is required for each firm to generate a proxy for idiosyncratic risk as well as to implement the two-step system-GMM methodology. The system-GMM estimation requires the second and higher lags of the variables included in the model as instruments.

  5. It should be noted that our definition of net equity issues does not include retained earnings as we consider changes in retained earnings as a separate component of leverage.

  6. Definitions of net equity issues, newly retained earnings, and net debt issues follow Baker and Wurgler (2002).

  7. Baker and Wurgler (2002), Hovakimian et al. (2004), and Kayhan and Titman (2007) also define the market-to-book ratio in similar way.

  8. The estimate on ARCH (0.781) is less than one and it is statistically significant at the 1 % level. The diagnostic test statistics indicate that there is no remaining ARCH effects left in the standardized residuals.The results for the ARCH estimation are not presented here to economize on space but are available from the author.

  9. This implies that the dependent variable is likely to follow either a unit root or near-unit root process.

  10. 10 Note that we include one-period lagged leverage as an explanatory variable to control for high-leverage and low-leverage effects. Since the leverage ratio is strictly confined between zero and one, a negative change in the leverage ratio is more likely to occur for high-leveraged firms, whereas, a positive change in the leverage ratio for low-leveraged firms is more likely to occur. Controlling for this effect by the inclusion of the lagged leverage in the regression, one may yield more explicit estimates of the effects of the other regressors.

  11. The positive effect of firm-specific risk on equity issues is consistent with the findings of Marsh (1982). In particular, using data on equity and debt issues by UK firms over the period 1959-1970, Marsh (1982) shows that firms are more likely to make equity issues rather than debt in periods when firm-specific risk is high.

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  1. International Institute of Islamic Economics (IIIE), International Islamic University, Islamabad, Pakistan

    Abdul Rashid

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  1. Abdul Rashid
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Correspondence to Abdul Rashid.

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Rashid, A. Security issuance decisions, idiosyncratic risk, and macroeconomic dynamics. J Econ Finan 41, 659–678 (2017). https://doi.org/10.1007/s12197-016-9370-x

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