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Capital structure adjustments: Do macroeconomic and business risks matter?

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Abstract

We show that risk plays an important role in estimating the adjustment of the firm’s capital structure. We find that the adjustment process is asymmetric and depends on the type of risk, its magnitude, the firm’s current leverage, and its financial status. We also show that firms with financial surpluses and above-target leverage adjust their leverage more rapidly when firm-specific risk is low and when macroeconomic risk is high. Firms with financial deficits and below-target leverage adjust their capital structure more quickly when both types of risks are low. Our investigation suggests that models without risk factors yield biased results.

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Notes

  1. Table 11, “Appendix 1,” displays the speed of adjustment estimates recently reported in the literature.

  2. Researchers have used either the full-adjustment or the partial-adjustment model to examine firms’ optimal/target leverage. The full-adjustment model assumes that the adjustment to the specific target leverage will be done in one step. In contrast, the partial-adjustment model assumes that the firm will attain the optimal leverage over time.

  3. To our knowledge, using a partial-adjustment model, the only other paper that explores the role of risk on capital adjustment problem is Dang et al. (2012). However, their risk measure is not time-varying, as their model only focuses on the impact of firms’ earnings volatility in low versus high regimes. Likewise, they allow for differing speeds of adjustment for above-threshold and below-threshold financing imbalances, but do not allow the speed of adjustment to vary with the magnitude of risk.

  4. Byoun (2008) investigates the importance of financial imbalances on capital adjustment when the firm is above or below its target level of debt. However, his research is silent about the role of risk.

  5. As good macroeconomic prospects (low macroeconomic risks) are positively related to the market value of equity, firms generally issue new equity during such periods.

  6. For theoretical underpinning regarding the effects of macroeconomic shocks on firms’ capital structure, see, including others, Bernanke and Gertler (1989), Calomiris and Hubbard (1990), Gertler (1992), Greenwald and Stiglitz (1993), Gertler and Gilchrist (1993), and Kiyotaki and Moore (1997).

  7. Also see Almeida and Campello (2010), and Öztekin and Flannery (2012) along these lines who examined inflation volatility effects on the firm’s capital structure.

  8. Among others, Taub (1975), Ferri and Jones (1979), Marsh (1982), Titman and Wessels (1988), Wald (1999), and Lemmon et al. (2008) present empirical evidence of a negative and statistically significant relationship between the firm-specific volatility/risk and leverage. Furthermore, several other studies, including Choe et al. (1993), Gertler and Gilchrist (1994), Korajczyk and Levy (2003), Drobetz et al. (2007), Cook and Tang (2010), and Akhtar, arrive at the conclusion that business cycles significantly affects firms’ capital structure.

  9. We mitigate sample selection and survivorship biases by allowing for both entry and exit in the sample.

  10. We restrict our attention to those firms which contribute at least 5 years of observations to generate meaningful measures of risk at the firm level and to properly instrument the endogenous variables in estimating our model.

  11. The data screening we implement here is commonly applied in the literature [e.g., see, including others, Brav (2009), Baum et al. (2009), Kayhan and Titman (2007), and Baker and Wurgler (2002)].

  12. See Shyam-Sunder and Myers (1999) and Frank and Goyal (2003) along these lines.

  13. Seasonally adjusted quarterly data spanning 1975Q1–2009Q4 on UK real GDP are taken from the Office for National Statistics (ONS) database (Pn: A2: ABMI: Gross Domestic Product: chained volume measure).

  14. The empirical correlation of the risk measures of 0.002 implies that each measure covers a different aspect of risk associated with the business and macroeconomic environment that firms face in their operations.

  15. Earlier research has shown that both volatility measures affect the firm’s capital structure.

  16. The results of the target leverage model are given in Table 13 of “Appendix 3.”

  17. Net equity issues are defined as the ratio of the change in book equity minus the change in retained earnings to total assets. Newly retained earnings are the change in balance sheet retained earnings during an accounting year period divided by the book value of total assets. Net debt issues are then defined as the ratio of the change in total assets to total assets less the sum of net equity issues and newly retained earnings.

  18. See Nickell (1981), Bond (2002), and Judson and Owen (1999) for more on related issues.

  19. The standard errors associated with adjustment speed estimate are estimated and reported in the table to test whether the estimated speed of adjustment statistically differs from zero. We compute these standard errors by taking partial derivatives of the estimated Eq. (6) with respective to \(\hbox {DVT}_{i,t}\), which is the deviation of observed (actual) leverage from the target leverage.

  20. We also test the relevance of firm-specific and macroeconomic risk in estimating the adjustment of firms’ leverage separately. In both cases, we reject the linear restriction on the parameters, as the p values are less than 0.05, suggesting the importance of both types of risks in adjustment of the firm’s capital structure.

  21. Unpredictable variations in macroeconomic conditions may cause rapid variations in firms’ market value, rendering the issuance of equity an unattractive source of finance for managers.

  22. We consider this narrow measure of leverage as an alternative measure because most of the previous studies in the empirical capital structure literature have utilized this measure (e.g., see Ozkan 2001; Flannery and Rangan 2006; Dang et al. 2012). However, it should be noted that the broader leverage measure has also been used by several researchers in the literature including Iliev and Welch (2010), Chang and Dasgupta (2009), and Kayhan and Titman (2007).

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Authors and Affiliations

  1. Department of Economics, Boston College, Chestnut Hill, MA, 02467, USA

    Christopher F. Baum

  2. Department of Macroeconomics, DIW Berlin, 10117, Berlin, Germany

    Christopher F. Baum

  3. School of Management and Languages, Heriot–Watt University, Edinburgh, EH14 4AS, UK

    Mustafa Caglayan

  4. International Institute of Islamic Economics, International Islamic University, 44000, Islamabad, Pakistan

    Abdul Rashid

Authors
  1. Christopher F. Baum
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  2. Mustafa Caglayan
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  3. Abdul Rashid
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Correspondence to Christopher F. Baum.

Additional information

Christopher F. Baum would like to thank independent referees and Heather M. Anderson for their constructive suggestions and comments. We would like to thank the participants at the EFMA, Rome 2014, conference for useful comments. The usual disclaimer applies.

Appendices

Appendix 1

See Table 11.

Table 11 Estimated capital structure adjustment speeds in prior empirical studies
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Appendix 2

See Table 12.

Table 12 Variable definitions
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Appendix 3

See Table 13.

Table 13 ARCH model estimates for macroeconomic risk
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Appendix 4

See Table 14.

Table 14 Robust two-step system GMM estimates for the determinants of leverage
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Baum, C.F., Caglayan, M. & Rashid, A. Capital structure adjustments: Do macroeconomic and business risks matter?. Empir Econ 53, 1463–1502 (2017). https://doi.org/10.1007/s00181-016-1178-1

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