RDP 9313: The Determinants of Corporate Leverage: A Panel Data Analysis 1. Introduction

This paper examines the determinants of capital structure decisions made by Australian non-financial corporations.

In a fundamental sense, the value of a firm is the discounted stream of expected cash flows generated by its assets. The assets of a firm are financed by investors who hold various types of claims on the firm's cash flows. Debt holders have a relatively safe claim on the stream of cash flows through contractual guarantees of a fixed schedule of payments. Equity holders have a more risky claim on the residual stream of cash flows. The mix of debt funds and equity funds (leverage) employed by a firm define its capital structure. Firms attempt to issue the particular combination of debt and equity, subject to various constraints, that maximises overall market value. The mix of funds affects the cost and availability of capital and, thus, firms' real decisions about investment, production and employment.[1]

Under certain restrictive assumptions, a firm's value is independent of its mix of debt and equity. This hypothesis is embodied in the original Modigliani and Miller (1958) value-invariance proposition. It relies upon the argument that the weighted average cost of capital remains constant as leverage changes (Copeland and Weston, 1983, p. 384). Assuming that the returns to investment projects are independent of the means used to finance them, this framework implies that leverage has no influence on the value of a firm's discounted stream of expected cash flows.

This controversial proposition has prompted a thorough investigation of the reasons why we observe a majority of firms placing a great deal of importance on their financial structure.[2] As Merton Miller (1988, p. 100) observed, ‘looking back now, perhaps we should have put more emphasis on the other, upbeat side of the “nothing matters” coin: showing what doesn't matter can also show, by implication, what does.’ The burgeoning literature relating financial structure to firm value has generated a number of theories predicting that a variety of firm, institutional and macro-economic factors should influence leverage decisions. In this paper we model leverage as a function of these suggested factors.

Panel data techniques are used to explore the relationship between leverage and its suggested determinants.[3] Lowe and Shuetrim (1992) describe, in full, the database used in this study. Models of leverage are estimated using both balanced and unbalanced samples of firms. The balanced sample contains 105 companies, each of which has data extending from 1973 to 1990. The unbalanced sample is comprised of 209 firms, each of which had a contiguous series of observations over a subset of the time dimension.[4]

Our results suggest that firms prefer to finance investments using retained earnings. We also find that leverage is positively related to size, growth and the percentage of a firm's assets that are collateralizable. In addition to these firm-related factors, we note an upward trend in leverage over the 1980s, much of which can be explained by movements in real asset prices. Finally, our results highlight the fact that unobserved characteristics of firms account for a large proportion of the cross-sectional variation in financial structure.

The rest of the paper is organised as follows. Section 2 reviews the recent theoretical and empirical literature on capital structure choice and outlines some general themes that emerge. Section 3 presents an empirical model of leverage based upon the determinants that emerge in the literature review. Section 4 reports estimation results from the balanced panel of firms. Finally, Section 5 summarises and concludes. The results from the unbalanced panel of firms are reported in Appendix 2.


See Mills, Morling and Tease (1993), Lowe and Rohling (1993), Cantor (1990), Bernanke and Campbell (1988) and the references cited therein. [1]

A management survey by Allen (1991) found that 75 per cent of companies sampled had a leverage target. Over 90 per cent of companies indicated that they had a policy of maintaining spare debt capacity. [2]

Recent empirical studies on corporate financial structure in Australia include Gatward and Sharpe (1992) and Allen (1992). [3]

We omit two types of firms from our sample: those that had negative equity and those that made losses that were greater than the value of the firm. These restrictions reduced the original sample of 224 firms used in the paper by Lowe and Shuetrim (1992) to a sample of 209 firms. [4]