RDP 9313: The Determinants of Corporate Leverage: A Panel Data Analysis 2. Capital Structure: Theory and Evidence

Theories of capital structure have been well documented in the literature and we provide only a short review here.[5] In this section we identify the main strands of the theoretical literature and draw out general principles that have enjoyed some empirical support in econometric studies and/or in management surveys. We also look at some macro-economic and institutional factors that may affect financial structure choices. These general themes provide a useful framework for assessing the recent Australian experience.

Modigliani and Miller's (1958) seminal paper on corporate financial structure is founded upon a number of restrictive assumptions. These assumptions include no transaction costs, no taxes or inflation, the equality of borrowing and lending rates, no bankruptcy costs and independence of financing and investment decisions. There is a substantial body of literature explaining the consequences of relaxing one or more of these assumptions. This literature demonstrates that, once the restrictive assumptions are relaxed, firms are able to alter their discounted stream of expected cash flows (their value) by varying leverage.

There are two main strands in the literature following Modigliani and Miller. The first strand implies an internal solution to the problem of optimising leverage. The internal solution (target leverage ratio) is defined as that mix of debt and equity which maximises the value of the firm. Firms equilibrate the costs of debt, relative to equity, to determine their optimal leverage. The second strand, in its strongest form, is distinguished by the implication that internal funds (retained earnings) are always cheaper than debt funds which are always cheaper than funds raised on external equity markets. As a result, leverage is determined by the demand for funds in excess of limited internal resources. This ‘fund cost hierarchy’ tends to arise from models that focus upon a single determinant of the relative costs of different fund types. When other wrinkles are introduced into the Modigliani-Miller framework, the fund cost differentials become blurred. This blurring helps explain why we tend to observe firms adopting a mix of fund types. Section 2.1 explores the first approach while Section 2.2 explores the second approach.

2.1 Target Leverage Models

Many papers have been written, beginning with Modigliani and Miller (1958), about the effects of introducing taxation into the Modigliani-Miller framework. Other papers have introduced the costs associated with bankruptcy and financial distress while others have added various transaction and agency costs (costs associated with conflicts of interest between debt holders, equity holders and firm management) to the models of financial structure. All of these costs are influenced by leverage. Below, we consider these various wrinkles in the original Modigliani-Miller framework.

2.1.1 Taxation

When taxation is introduced into the model, cash flows are divided between debt holders, equity holders and the government. The value maximising capital structure becomes that which minimises the portion of cash flows that goes to the government. By incorporating a tax on corporate profits, Modigliani and Miller (1958 and 1963) show that tax deductibility of interest payments make it optimal for firms to rely entirely upon debt. Miller (1977) extends this work, deriving an expression for the gain from leverage when different tax rates are applied to corporate profit, personal earnings from stocks and personal interest earnings. He shows that the incentive to finance completely through debt disappears under a variety of tax regimes. Most significantly for Australia, the gains from leverage are zero if full dividend imputation occurs and the marginal income tax rate for the investor is equal to the corporate tax rate. Pender (1991) gives a thorough analysis of the tax bias toward debt in Australia while Pender and Ross (1993) and Callen, Morling and Pleban (1992) discuss the effects of dividend imputation.

In his 1977 paper, Miller also suggests that clientele effects (whereby firms attract those investors that suit their degree of leverage) may reduce or negate the tax related gains from leverage for any single firm.

DeAngelo and Masulis (1980) emphasise that the tax induced gains from leverage are reduced if a firm's expected income stream, against which interest expenses can be deducted, is less than the firm's total interest expenses. Importantly, they note that the presence of deductions from taxable income, other than interest payments, reduces the expected gains from leverage. These non-interest tax deductions are generally known as ‘non-debt tax shields’. Examples include accelerated depreciation allowances and investment tax credits.

Despite these offsetting factors, it appears that the tax system remains an important influence on capital structure choice. In Allen's (1991) survey of listed Australian companies, 85 per cent of firms stated that tax issues have a major impact on capital structure decisions.

Two implications of the influence of taxation on capital structure choices are: (i) optimal leverage may increase as corporate tax rates rise (Furlong, 1990), and (ii) optimal leverage may increase with the amount of income against which firms expect to be able to offset interest expenses (Kale, Noe and Ramirez, 1991).

2.1.2 Bankruptcy and Financial Distress Costs

In the Modigliani-Miller world there are no bankruptcy costs. In the event that a firm is unable to meet contractual obligations, the firm is costlessly transferred to its bondholders. In reality, bankruptcy imposes both direct and indirect costs on the firm. Direct costs include legal expenses, trustee fees and other payments that accrue to parties other than bondholders or shareholders. Indirect costs include disruption of operations, loss of suppliers and market share and the imposition of financial constraints by creditors. These indirect costs of bankruptcy (and the financial distress costs that may occur even if the firm does not enter bankruptcy) can be very significant. Altman (1984) finds that indirect bankruptcy costs average 17.5 per cent of firm value one year prior to bankruptcy. These bankruptcy/financial distress costs carry a number of implications for capital structure choices.

First, optimal debt levels may be inversely related to measures of financial risk (for example, cash flow volatility). Empirical support for this relationship is mixed. Castanias (1983) and Bradley, Jarrell and Kim (1984) find an inverse relationship between corporate leverage and business risk but Long and Malitz (1985) find evidence of a positive relationship. Titman and Wessels (1988) conclude there is no significant relationship between the variables.

Second, optimal leverage ratios may be positively related to firm size. If bankruptcy costs include a fixed component, these costs constitute a larger fraction of the value of a firm as firm size decreases (Ang, Chua and McConnell, 1982). Large companies may also have lower risk through diversification, more stable cash flows and established operating and credit histories. These factors provide large firms with greater access to alternative sources of finance in times of financial distress. This may reduce the present value of expected bankruptcy costs for large firms, thus encouraging them to take on relatively high debt burdens.

Third, leverage may be positively related to the value of firms' collateralizable assets or liquidation values (Gertler and Gilchrist, 1993, Bradley, Jarrell and Kim, 1984 and Chaplinsky and Niehaus, 1990). Higher liquidation values reduce the expected losses accruing to debt holders in the event of financial distress, thus making debt less expensive.

2.1.3 Agency Costs

Agency costs of debt are borne by firm owners as the result of potential conflicts between debt holders and equity holders and between managers and equity holders (see Harris and Raviv, 1991, and references cited within). The choice of capital structure can, in some circumstances, reduce the costs arising from these conflicts.

Jensen and Meckling (1976) highlight the agency costs arising from the fact that equity holders have limited liability while debt holders have fixed maximum returns. In the event that an investment is successful, equity holders capture most of the gain. If the investment is unsuccessful, however, debt holders share the burden with equity holders. This asymmetry of expected returns may provide incentives for managers, acting on behalf of equity holders, to pursue risky investment projects, even where those projects have a negative net present value.

Alternatively, agency costs may arise between managers and equity holders if projects are financed using debt. Because managers stand to lose their jobs, their reputation and their firm-specific capital in the event of financial failure and because they cannot diversify this risk, managers may choose not to engage in projects with positive net present values if they must use debt finance (Lowe and Rohling, 1993). This type of agency cost can be reduced by the use of equity fund sources.

Jensen (1986) also proposes a ‘control hypothesis’ that focuses upon a type of agency cost which can be reduced by high debt levels. He argues that if a firm has large free cash flows (cash flows in excess of those required to finance all projects with positive net present values) then managers may spend funds on projects with negative net present values. Jensen suggests that managers have an incentive to waste funds in this way because management remunerations are positively correlated with firm size. High debt may diminish this incentive because the interest burden reduces free cash flow. Jensen postulates that this incentive towards debt eventually balances the other agency costs associated with high debt levels to determine the firm's optimal leverage.

While the agency cost literature is replete with theoretical models, testable implications are scarce. One testable implication is that a negative relationship exists between leverage and firms' growth opportunities. This negative relationship arises in two ways. Titman and Wessels (1988) note that, because growth opportunities are not fully collateralizable (they are very difficult to monitor and value), creditors demand a relatively high return when providing finance for these opportunities. Thus, firms with significant growth opportunities are expected to look to equity rather than debt as a source of finance. Similarly, firms in growing industries may have greater flexibility in their choice of investments, allowing equity holders greater freedom to expropriate wealth from bondholders. Either way the costs of debt for rapidly growing firms may lead to a preference for equity funds.

In summary, agency cost theories imply that corporate leverage is chosen, in a rather complex fashion, to reduce the capacity of shareholders to act in a manner contrary to the welfare of bondholders and to reduce managers' capacity to act in a manner contrary to shareholders' interests. Empirical support for the implications of agency costs is mixed. Titman and Wessels (1988) find that leverage is inversely related to firms' growth opportunities while Kester (1986) does not find a significant relationship. The results in Long and Malitz (1985) are inconclusive. The theoretical predictions that leverage is positively associated with default probability and with free cash flow are rejected by Castanias (1983) and Chaplinsky and Niehaus (1990) respectively.

2.2 Financing Hierarchies

Some theories of corporate financial structure suggest that internally generated cash flows are the cheapest form of finance, debt is the next most expensive form and external equity is the most expensive form. To minimise the total cost of funds, managers use the cheapest fund sources first. However, given that internal fund sources are limited, firms are often forced to look beyond their internal resources to credit and equity markets and to pay the premiums attached to these external sources.

Fund cost hierarchies are consistent with a variety of wrinkles in the Modigliani-Miller framework, the most commonly referenced being those related to asymmetric information issues. However, transaction costs, flexibility, liquidity constraints and ownership dilution considerations can all lead to an overriding preference for internally generated funds. These theories are outlined below.

2.2.1 Asymmetric Information

In their most basic form, asymmetric information theories argue that managers have more information about the firm than do investors. Investors, knowing this, infer that managers are more likely to raise equity when share prices are over-valued. With this understanding, investors price equity issues at a discount. This discounting of share issues can force firms to forego projects even though they have positive net present values. The prohibitive costs of external equity can be sidestepped, however, if firms are able to use retained earnings. The problem can also be partly overcome by firms if they develop a reputation of providing true and accurate information.

Asymmetric information can also generate a premium on debt funds through the same mechanism. Again, the premium can force firms with exhausted internal funds to forego some projects with positive net present values. However, the premium on debt will be less than that on external equity because debt contracts involve less risky streams of income and hence debt is less prone to sharp revaluations when the true values of investments are revealed. As a result, firms may tend to use internal funds first, then debt and finally externally raised equity. See, for example, Myers and Majluf (1984) and references cited in Harris and Raviv (1991).

2.2.2 Transaction Costs, Flexibility, Liquidity Constraints and Ownership Dilution

A variety of market imperfections are also capable of explaining variation in the relative costs of different fund types. First, costs and delays involved in raising funds on equity markets (for example, broker charges, underwriting fees and the issue of prospectuses) may lead to a preference for internal equity and debt over external equity. An assumption in the Modigliani-Miller value-invariance proposition is that capital markets are frictionless (there are no transaction costs and transactions occur instantaneously). In practice, however, this is not the case. As noted in Allen (1991, p. 113), ‘many [companies] stated that equity issues were costly and time consuming … debt funding had the advantage of being quick to obtain’. Firms may prefer internal funds and debt because transaction costs are lower, especially for smaller firms, and because they give firms the flexibility to respond quickly as investment opportunities arise. This is supported by the Industry Commission's ‘Availability of Capital’ report (1991, p. 155) which suggests that the larger the equity issue, the cheaper are the fees associated with issuance.

It should be noted that debt involves slower access and higher transaction costs than internal fund sources which can be brought to bear almost immediately. This may lead to a preference for internal funds over debt.

Second, some firms may prefer to maintain informational asymmetries. If internal funds are used, there is no requirement to subject the firm to external scrutiny. Similarly, where debt finance is used, information is provided to bankers, but there is no requirement for the disclosure of information to the capital market, competitors, or to shareholders. The advantages of privacy and the costs of releasing information may generate a fund cost hierarchy.

Third, when new equity is issued to new owners, it may dilute the claims of existing shareholders. Pinegar and Wilbricht (1989) list the dilution of shareholders' funds as an important consideration in the capital structure decisions of US managers.

A financing hierarchy implies that the observed mix of debt and equity reflects firms' cumulative requirements for external finance and this, in turn, reflects the relationship between cash flows and investment demands. Which of these various factors are primarily responsible for the observed preferences for internal funds over debt is conjectural. However, it is likely that each factor has some influence. In any event, empirical support for financial hierarchies is strong. Fund cost hierarchies imply a negative relationship between cash flow and leverage because, as cash flows increase, firms are able to rely more heavily on internal funds. Also, if firms operate under a fund cost hierarchy, those with large growth opportunities should assume larger debt burdens. This behaviour is anticipated because firms will have exhausted their internal fund resources.

These predictions are borne out in recent papers by Chaplinsky and Niehaus (1990) and Amihud, Lev and Travlos (1990). These papers find evidence that there is a ‘pecking order’, with firms preferring internally generated funds over external securities. Allen's (1991) management survey found that more than half of the firms had a preference for internal funds and the remainder generally preferred a mix of internal funds and some debt. Where new finance was required, debt was preferred. The issue of equity was not the preferred source of funds for any of the respondents. These findings are consistent with the US management survey by Pinegar and Wilbricht (1989) which found that 84 per cent of respondents ranked internal equity as their first choice of finance.

A caveat must be placed upon the predictions of the fund cost hierarchy models. There are significant costs associated with extreme reliance upon a single fund source. For example, a strong preference for internal funds, resulting in very low levels of debt, may expose a firm to takeovers that could be financed using the firm's own debt capacity. Also, a heavy reliance upon debt results in high risks of bankruptcy. Nevertheless, the cost structures underlying the fund cost hierarchy may well govern firms' preferred fund sources over moderate ranges.

2.3 Macro-economic and Institutional Characteristics

The evolution of Australian corporate balance sheets, over the last two decades, has been documented by Lowe and Shuetrim (1992).[6] After remaining relatively constant through the 1970s, leverage increased substantially between 1982 and 1988. In large part, this rise was facilitated by the liberalisation of Australia's financial markets during the first half of the 1980s.[7]

Prior to liberalisation, banks were often forced to ration credit. Controls on both lending growth and interest rates meant that banks could not use prices to equate loan supply and demand. As a result, increased demand for debt often meant that the queue of borrowers simply lengthened. Following deregulation, this need to ration credit disappeared.

At around the same time as the deregulation of Australia's financial markets, there was a cyclical pick-up in economic activity and a change in factor shares towards profits. To some extent, an increase in asset prices was justified in terms of fundamentals; higher profits and dividends for equity holders and higher rents for property owners. However, the improvement in fundamentals led, not only to legitimate increases in real asset prices, but set off speculative increases over and above those justified by the fundamentals.[8] The increase in real asset prices raised the value of ‘collateral’ for many firms and, as Lowe and Rohling (1993) suggest, this collateral increased both the willingness of financial institutions to extend credit and the willingness of firms to seek credit. This process may have added further stimulus to asset prices. More recently, falls in real asset prices have worked in the opposite direction, both increasing the difficulty of obtaining debt finance and reducing the willingness of managers to apply for debt finance.

In addition to increases in real asset prices, general goods price inflation may also provide an incentive towards high leverage because of the tax deductibility of nominal interest payments. Nominal interest payments can be separated into two components, one compensating creditors for the decline in the expected real value of their principal and the other for the use of the borrowed funds (the real interest paid). The borrower receives a tax deduction, not only on that component which reflects the real cost of funds but also on that part which represents compensation for reduction in the real value of the principal. The higher is inflation, the greater is the tax deduction gained through this second component. However, as discussed earlier, the tax advantages of debt disappear under certain conditions. In particular, if borrowing rates increase more than one for one with inflation (to keep after tax real returns unchanged) the increased tax deduction that inflation creates may be completely offset by higher borrowing costs.

It is also likely that an aggregate measure of the real cost of debt and an aggregate measure of the real cost of equity influence firms' gearing decisions. In equilibrium, the cost of debt, plus some risk premium, should be equal to the cost of equity. However, equilibrium conditions may not hold continuously. If this is the case, and if the deviations in the relative real cost of debt are not just firm-specific, then this factor may influence managers' gearing decisions. When the real cost of debt rises relative to the real cost of equity, firms can be expected to increase their gearing.

2.4 An Overview

Our review of the literature reveals several general principles that have some empirical support and which may be reflected in the Australian data.

  • Within moderate ranges, firms should exhibit a preference for internal funds over external securities. Again within moderate ranges, when external funds are required, firms should prefer debt to equity. The preference for internal funds should be evident in a negative relationship between firms' cash flow and their reliance on debt.
  • The various costs (explicit and implicit) associated with external finance may be lower for those firms with smaller informational asymmetries between the various stakeholders (debt holders, equity holders, managers, creditors, customers, and employees). They may also be smaller for large firms.

If firms require external funds, then their leverage is determined by the tradeoff between the relative costs of debt and equity as proposed by the first strand in the corporate financial structure literature. Most importantly:

  • Leverage should be negatively related to firms' inherent riskiness through the effect of risk on the expected costs of bankruptcy and financial distress. This implies that leverage may be positively related to collateral (the proportion of a firm's assets that are readily resaleable) and negatively related to cash flow volatility.
  • Leverage should be set by firms to minimise their effective tax rates. This link ought to vary across firms but will not be clearly observed. Also, the tax advantages of debt should decline if interest payments cannot be fully deducted from earnings.
  • Leverage may be positively or negatively related to growth depending upon whether the fund cost hierarchy approach or the leverage target approach is of primary importance.

Above and beyond these firm-specific considerations are more general determinants of leverage. These fall within two categories:

  • General macro-economic factors such as real asset prices, consumer price inflation and the differential between the real cost of debt and the real cost of equity may affect capital structure decisions by altering the availability of funds, the relative costs and benefits of alternative funding sources and by changing the demand for funds.
  • Institutional factors such as the degree of regulation may also affect firms' capital structure choices.

These general themes provide a guide towards the determinants of leverage that are included in our empirical model.


See literature surveys by Harris and Raviv (1991) and Masulis (1988). [5]

Mills, Morling and Tease (1993) examine changes over the last few years. [6]

Underlying these developments has been a trend rise in the use of external financing in other parts of the world (Masulis, 1988). [7]

For greater detail see Macfarlane (1989 and 1990) and Stevens (1991). [8]