The Choice Between Equity and Debt: An Empirical Study

Abstract

This empirical study of security issues by UK companies between 1959 and 1974 focuses on how companies select between financing instruments at a given point in time.It throws light on a number of interesting questions. First, it demonstrates that companies are heavily influenced by market conditions and the past history of security prices in choosing between debt and equity. Second, it provides evidence that companies appear to make their choice of financing instrument as if they have target levels of debt in mind. Finally, the results are consistent with the notion that these target debt levels are themselves a function of company size, bankruptcy risk, and asset composition. AN IMPORTANT QUESTION FACING companies in need ofnew finance is whether * London Business School, London. I would like to thank Professor Richard Brealey, Dr. Ian Cooper, and participants at the London Business School Finance Workshop for their very useful comments and suggestions. 121 122 The Journal of Finance I. Theoretical Background In principal, companies needing new finance should issue equity if they are above their target debt level and debt if they are below. With no flotation costs, such adjustments could be made instantaneously and continuously. In practice however, the existence of significant flotation costs means that companies should plan issues to minimize both flotation costs and the costs of deviating from their target ratio. This gives rise to infrequent "lumpy" issues, with debt ratios over time fluctuating around their target.' Clearly, in any empirical work, it is important to identify what this target level is. However, since it is unobservable, we can do this only by looking at past behavior or by turning to the theory of capital structure for help. Unfortunately the theory provides only limited guidance. More than twenty years after Modigliani and Miller's [26] original article, the theoretical debate is still centered on the most fundamental of issues. There are, nevertheless, two points of broad agreement. First, in spite of fundamental differences about the way in which it is important, virtually everyone stresses the importance of tax.2 Second, most people would accept that managers are likely to set debt levels with due regard to the expected costs of bankruptcy and financial distress.3 The implications for target debt levels and hence issue behavior are clear. First, any overall change in tax levels could cause issuing companies to shift their preferences towards either debt or equity. This will be true regardless of whether this is a temporary effect lasting only until equilibrium is restored (see Miller [25]), or whether it represents a permanent shift in companies' target ratios.4 Second, target debt levels will be influenced by the probability of financial distress. Since the latter is a function of both operating and financial risk, it seems reasonable to expect companies with high operating risk to use less debt.Given the incomplete and somewhat unsatisfactory state of the theory, little more can be sai...

Financial Leverage and Corporate Taxation: Evidence from German Corporate Tax Return Data

“…According to this hypothesis, other corporate tax shields, such as depreciation allowances and tax loss carry-forwards, may substitute for debt and thus affect the financial leverage elasticity with respect to the tax rate. 3 The older empirical literature (see, e.g., Bradley, Jarrell, and Kim 1984, Marsh 1982, Titman and Wessels 1988, Fischer, Henkel and Zechner 1989 could not find convincing evidence supporting this hypothesis. MacKie-Mason (1990) argues that this may be due to the fact that previous studies analyzed debt ratios, which cumulate decisions made over many years, taken under varying circumstances.…”

Behavioral Corporate Finance: A Survey

“…find that aggregate IPO volume and stock market valuations are highly correlated in most major stock markets around the world. Similarly, Marsh (1982) examines the choice between (seasoned) equity and long-term debt by UK quoted firms between 1959 and 1974, and finds that recent stock price appreciation tilts firms toward equity issuance. In US data, Jung, Kim, and Stulz (1996) and Hovakimian, Opler, and Titman (2001) also find a strong relationship between stock prices and seasoned equity issuance.…”

“…On the empirical side, Marsh (1982), in his sample of UK firms, finds that the choice between debt and equity does appear to be swayed by the level of interest rates. And Guedes and Opler (1996) examine and largely confirm the survey responses regarding the effect of the yield curve.…”

Análise dos determinantes do endividamento das empresas de capital aberto do agronegócio brasileiro

“…Marsh (1982): a) Divida de longo prazo = Dívida de longo prazo + ações pre fe ren ci ais / capi tal total. ; b) Divida de curto prazo = Dívida de curto prazo/finan ci a men tos totais.…”

“…(2002), empresas maiores tendem a ser mais diversificadas e apresentarem menor risco de falência, podendo, portanto, carregar um maior endividamento. Marsh (1982) espera que a proporção entre dívidas de longo prazo e curto prazo seja maior para as empresas maiores. As empresas menores devem ter suas dívidas concentradas no curto prazo.…”