Dynamic Capital Structure Choice: Theory and Tests

In this article, we consider the impact of asymmetric information between managers and investors on the optimal capital structure decision. This is done within a continuous-time framework, where the relevant state variable is given by the EBIT value of the firm; an approach taken by (2004) amongst others. Our setup differs in that we assume the EBIT to follow an Arithmetic Brownian motion, i.e. it can assume negative values. More importantly, we extend this framework in two directions: (i) We introduce a separate management claim. (ii) We introduce asymmetric information between managers and investors by assuming that claimants receive noisy signals, which they process according to rational expectation principles.Our results show, that managers always try to avoid debt, and that their optimal bankruptcy threshold is always lower, than the threshold set by equity holders. The introduction of asymmetric information changes the optimality conditions, and consequently the capital structure decision. It is shown, that the informational asymmetry can substantially lower the optimal leverage ratio, even without assuming that managers are entrenched.

Section: Literature Reviewmentioning

confidence: 99%

Section: Literature Reviewmentioning

confidence: 99%

See 1 more Smart Citation

Informational Asymmetry Between Managers and Investors in the Optimal Capital Structure Decision

Bank

Lawrenz

2005

“…Myers conjectured that costs of adjusting capital structure might account for some empirical patterns but argued in the absence of explicitly modeling the consequences of these costs trade-off theory must be found wanting. Fischer et al (1989) demonstrated that in the face of discrete adjustment costs optimal level of debt would be adjusted only from time to time, implying that observed leverage would exhibit inertia. More recent explorations of dynamic trade-off models of capital structure have shown that these models are consistent with a number of empirical regularities.…”

Section: Introductionmentioning

confidence: 99%

Liquidity and Capital Structure

Carverhill

2011

Liquidity and Capital Structure* This paper solves for a firm's optimal cash holding policy within a continuous time, contingent claims framework that has been extended to incorporate most of the significant contracting frictions that have been identified in the corporate finance literature. Under the optimal policy the firm targets a level of cash holding that is a non-monotonic function of business conditions and an increasing function of the amount of long-term debt outstanding. By allowing firms to either issue equity or to borrow short-term, we show how share issue and dividends on the one hand and cash accumulation and bank borrowing on the other are all mutually interlinked. We calibrate the model and show that it matches closely a wide range of empirical benchmarks including cash holdings, leverage, equity volatility, yield spreads, default probabilities and recovery rates. Furthermore, we show the predicted dynamics of cash and leverage are in line with the empirical literature. Despite the presence of significant contracting frictions we show that the model exhibits a near irrelevance of long-term capital structure property. Furthermore, the optimal policy exhibits a state-dependent hierarchy among financing alternatives that is consistent with recent explorations of pecking order theory. We calculate the agency costs generated by the conflict of interest between shareholders and creditors regarding the firm's liquidity policy and show that bond covenants that establish an earnings restriction on dividend payments may be value increasing.JEL Classification: G30 and G32

“…Over the years, this has fundamentally focussed on large corporations which have publicly traded equity and debt in developed economies (for example see Allayannis, Brown, & Klapper, 2003;Baker & Wurgler, 2002;Berger & Bonaccorsi di Patti, 2006;Bevan & Danbolt, 2004;Brounen, De Jong, & Koedijk, 2006;DeAngelo & Masulis, 1980;Desai, Foley, & Hines, 2004;Fischer, Heinkel, & Zechner, 1989;Hovakimian, 2006;Kale, Noe, & Ramirez, 1991;Kayhan & Titman, 2007;Miao, 2005;Rajan & Zingales, 1995;Ross, 2005;Wald, 1999a). Studies have also been undertaken in developing and transitional economies more recently.…”

Section: Introductionmentioning

confidence: 99%

Leverage, Profitability and the Ownership Structures of Listed Firms in China

Hovey

2007

The relationship between leverage, profitability and a firm's ownership structure in China is investigated in this paper. It is an exploratory study based on all firms listed on the Shanghai and Shenzhen stock exchanges from 1999 to 2005. The results of the empirical analysis are reported in this paper.The most significant result is that foreign holdings are found to have a significant relationship with the leverage of listed firms in China. Whereas, somewhat unexpectedly, institutional ownership, through legal person holding companies, state ownership and private holdings are not found to have a significant relationship with the capital structure choices of firms in China. The results also suggest that some firm-specific factors that are relevant for explaining firm leverage generally referred to in studies in developed economies, such as profitability, growth opportunities, size and tax shields, are also relevant in China. The age of the firms and the industry t o which they principally belong also has significant bearing. Yet direct government grants and the use of an internationally renowned auditing firm do not show a significant relationship.