Vidhan K. Goyal

Testing the Pecking Order Theory of Capital Structure

The pecking order theory of corporate leverage is tested against the static tradeoff theory of corporate leverage, using a broad cross-section of US firms over the period 1980-1998. A derivation of the conditional target adjustment framework is provided as a better empirical test of mean reversion. None of the predictions of the pecking order theory hold in the data. As predicted by the static tradeoff theory, robust evidence of mean reversion in leverage is found. This is true both unconditionally and conditionally on financial factors. Leverage is more persistent at lower levels than at higher levels. When debt matures, it is not replaced dollar for dollar by new debt and so leverage declines. Large firms increase their debt in order to support the payment of dividends. By contrast, small firms reduce their debt while they pay dividends.

Board Leadership Structure and CEO Turnover

We study whether bestowing chief executive officer (CEO) and board chairman duties on one individual affects a boards decision to dismiss an ineffective CEO. The results show that the sensitivity of CEO turnover to firm performance is significantly lower when the CEO and chairman duties are vested in the same individual. These results are consistent with the view that the lack of independent leadership in firms that combine the CEO and Chairman positions makes it difficult for the board to remove poorly performing managers.

Trade-Off and Pecking Order Theories of Debt

Taxes, bankruptcy costs, transactions costs, adverse selection, and agency conflicts have all been advocated as major explanations for the corporate use of debt financing. These ideas have often been synthesized into the trade-off theory and the pecking order theory of leverage. This chapter reviews these theories and the related evidence and identifies a number of important empirical stylized facts. To understand the evidence, it is important to recognize the differences among private firms, small public firms, and large public firms. Private firms use retained earnings and bank debt heavily; small public firms make active use of equity financing; and large public firms primarily use retained earnings and corporate bonds. The available evidence can be interpreted in several ways. Direct transaction costs and indirect bankruptcy costs appear to play important roles in a firm’s choice of debt. The relative importance of the other factors remains open to debate. No currently available model appears capable of simultaneously accounting for all of the stylized facts.

Creditor Rights, Enforcement, and Bank Loans

We examine whether differences in legal protection affect the size, maturity, and interest rate spread on loans to borrowers in 48 countries. Results show that banks respond to poor enforceability of contracts by reducing loan amounts, shortening loan maturities, and increasing loan spreads. These effects are both statistically significant and economically large. While stronger creditor rights reduce spreads, they do not seem to matter for loan size and maturity. Overall, we show that variation in enforceability of contracts matters a great deal more to how loans are structured and how they are priced.We use data from 36 countries to examine how property rights affect loan spreads (over the London Interbank Offered Rate) in international bank loans. Banks charge higher loan spreads when property rights are weaker suggesting that recontracting and monitoring costs are larger in countries with weak property rights environments. The findings are robust to consideration of a large number of plausible macroeconomic and institutional factors. The findings are also robust to controlling for variation in observable risk characteristics of borrowers across countries. The effects are also economically large. If a country improved its property rights protection from the 33 rd percentile to the 67 th percentile, loan spreads would decline by 81 basis points.

THE INVESTMENT OPPORTUNITY SET AND ITS PROXY VARIABLES

We use a real options approach to evaluate the performance of several proxy variables for a firms investment opportunity set. The results show that, on a relative scale, the market-to-book assets ratio has the highest information content with respect to investment opportunities. Although both the market-to-book equity and the earnings-price ratios are related to investment opportunities, they do not contain information that is not already contained in the market-to-book assets ratio. Consistent with this finding, a common factor constructed from several proxy variables does not improve the performance of the market-to-book assets ratio. 2008 The Southern Finance Association and the Southwestern Finance Association.

On the Patterns and Wealth Effects of Vertical Mergers

We use industry commodity flows information to measure vertical relations in completed mergers from 1962 to 1996. Almost one-third of the mergers display vertical relatedness. Vertical merger activity is more intensive in the 1980s and 1990s and less so in the 1960s and the 1970s. Vertical mergers generate positive wealth effects that are significantly larger than those for diversifying mergers; the wealth effects in vertical mergers are comparable to those in pure horizontal mergers.

Growth Opportunities and Corporate Debt Policy: The Case of the U.S. Defense Industry

The U.S. defense industry provides a natural experiment for examining how changes in growth opportunities affect the level and structure of corporate debt. Compared with other firms, the growth opportunities of defense firms increased substantially during the Reagan defense buildup of the early 1980s, but then declined significantly with the end of the cold war and associated defense budget cuts in the late 1980s and early 1990s. We examine how the level and structure of corporate debt changed for a sample of 61 defense firms and a benchmark sample of 61 manufacturing firms during 1980-1995, a period spanning the changes in growth opportunities. The debt levels of weapons manufacturers, which were most affected by the changes in growth opportunities, increased significantly as their growth opportunities declined. In addition, these firms lengthened the maturity structure of their debt, decreased the ratio of private to public debt, and decreased the use of senior debt as their growth opportunities declined. The results complement other studies that have found cross-sectional relations between proxies for growth opportunities and leverage variables and validate the prominent role played by growth opportunities in the theory of corporate finance.

The Effect of Market Conditions on Capital Structure Adjustment

The empirical implications of the trade-off theory, the market timing theory, and Welchs (2003) theory of capital structure are examined using aggregate US data for 1952 to 2000. There is a long-run leverage ratio to which the system reverts. Deviations from that ratio help to predict debt adjustments, but not equity adjustments. A high market-to-book ratio is associated with subsequent debt reduction, but there is no effect in the equity market.

Bank monitoring and the maturity structure of Japanese corporate debt issues

Abstract Extant literature suggests that bank lending results in greater information production and control over corporate borrowers. We show that bank lending creates positive externalities in that it improves the contracting environment for other public debt providers. Focusing on the maturity structure of Japanese corporate debt issues, we provide evidence that a higher proportion of bank debt results in public debt of longer maturity. More importantly, the sensitivity of the debt maturity to bank debt ratio is significantly higher for independent firms compared with that of keiretsu-affiliated firms. The evidence is consistent with keiretsu firms having less agency costs of debt compared with independent firms.

A corporate bond innovation of the 90s: The clawback provision in high-yield debt

Abstract This paper examines a recent financial innovation in corporate bond contracts, referred to as the clawback provision. A clawback provision in debt contracts gives the issuer an option to redeem a specified fraction of the bond issue within a specified period at a predetermined price and with funds that must come from a subsequent equity offering. We argue that issuers use clawback provisions to mitigate the wealth losses that would otherwise occur when new equity is offered. Consistent with the hypotheses, the evidence shows that bond offerings are more likely to include a clawback provision if their issuers are private, have more intangible assets, have fewer liquid assets, and are unregulated. We also estimate the price of clawback provisions and find that yield spreads on bonds with clawback provisions are a median of 86 basis points higher relative to what they otherwise would be.