RDP 9313: The Determinants of Corporate Leverage: A Panel Data Analysis 5. Summary and Conclusions

The theoretical and empirical literature identifies a wide variety of possible influences on corporate capital structures. It is difficult to define tests that accurately discriminate between the competing theories. The approach adopted in this paper is to identify and estimate a fairly broad empirical model that incorporates many of the variables that have received support in the literature. This approach allows us to draw fairly general conclusions but does not allow us to distinguish between competing models of leverage.

Our results suggest that both firm-related and macro-economic factors influence the leverage of Australian corporations. The dominant factor driving variation in leverage across firms is firm size. Our results suggest that large firms enjoy considerable advantages over their smaller competitors in the credit markets. Furthermore, this advantage would appear to have been maintained after financial deregulation. Other factors that are important in explaining the variation in leverage across firms include cash flows, real tangible assets and growth in the real size of firms' balance sheets.

Over the time dimension, size is again an important factor, explaining a large proportion of the increase in leverage between 1974 and 1990. Much of the remaining variation in leverage over time can be explained by the macro-economic variables and, more specifically, by real asset prices. Our fixed firm effects model suggests that, over the 1980s, rising real asset prices explain, on average, approximately 25 per cent of the average increase in leverage over the same period.

In contrast to the prominent role of real asset prices, consumer price inflation is not significant in our specification. This finding suggests that perhaps the importance of the tax deductibility of interest rates has been exaggerated. Instead, the insignificance of inflation is consistent with creditors adjusting the nominal rate of interest on a more than one for one basis with changes in the rate of inflation. In this way they compensate themselves for the reallocation of wealth implicit in the nominal tax system.

The deregulation of the Australian financial system would also appear to have an important role in explaining movements in leverage over the time dimension. The results in Appendix 3 show how the relationship between leverage and its determinants vary between the pre- and post-deregulation periods. Prior to deregulation, increases in asset prices had an insignificant influence on leverage because firms were credit constrained. Following deregulation, increasing asset prices stimulated firms to increase their leverage and to increase the size of their balance sheets. Firms, observing that the rates of return from assets were increasing, accelerated their asset accumulation and largely financed their purchases using credit. These newly purchased appreciating assets were then used, in many cases, as collateral when applying for further credit. Because market values were increasing so rapidly, and because, to a large extent, these market values were being used when evaluating credit worthiness, the increasing asset prices sparked rising dependence upon debt and a corresponding increase in exposure to economic shocks. Thus, although deregulation is not included specifically in our model of leverage, it can be seen to have had a pervasive and significant influence on firms' corporate financial structures.

Finally we place two related caveats upon our results. First, the panel data specification imposes the same model, with the same coefficients, in both the cross section and in the time domain. While this is standard practice, it may be inappropriate. Second, although leverage is clearly determined on the basis of many real factors, our understanding of the dynamic relationships between these factors and leverage is incomplete. Our results suggest an extremely slow rate of adjustment. However, the partial adjustment mechanism used to describe these dynamics is imprecise. The response of leverage may vary depending upon the nature of the shock and depending upon the duration of the shock. These issues are important topics for future research, especially in light of the uncertainty about the speed with which firms can reconstruct their balance sheets.