Advanced Corporate Finance: Research Article Review

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Advanced Corporate Finance

Writing Assignment: Research Article Review

Article #4: Capital structure adjustment (Byoun 2008)

1. Motivation of Study

Previous studies have discussed the pecking order theory verses the traditional trade-off theory and its impact on capital structure. In this paper a financing needs-induced adjustment framework is used to determine the dynamic process by which firms adjust their capital structures. This study is to prove that neither the pecking order theory nor the traditional trade-off theory is correct on its own but rather in unison.

2. Importance of Study

Below is a list of all relevant studies done prior to this study being done:

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  • Fama and French (2005): This study showed that the pecking theory and the trade-off theory both help explain some aspects of financing decisions and should not be isolated ideas alone.
  • Barclay and Smith (2005): This study showed that information costs will influence corporate financing choices and, along with other costs and benefits, must be part of a unified theory of corporate financial policy.
  • Myers and Majluf (1984): This study showed that adverse selection costs are the main aspect of information used to make capital structure decisions while utilizing the pecking order theory.
  • Frank and Goyal (2003), Fama French (2002), Barclay and Smith (2005): These studies all showed that adverse selections costs are only one aspect of the decision-making process.
  • Leary and Roberts (2005), and Strebulaev (2007): These studies showed that some firms preferred internal funding instead of outside funding for the cost difference of the funding.
  • Hovakimian, Opler, and Titman (2001), and Hovakimian, Hovakimian, and Tehranian (2004): These studies also supported the idea that some firms prefer internal financing due to the being more cost effective.
  • Baker and Wurgler (2002), and Welch (2004): These studies showed that firms do not change their capital structures immediately due to the ever-changing market.

The Previous studies done on how and when firms adjust their capital structures toward targets show that firms are most likely to make an adjustment when they have a financial deficit with below target debt or a financial surplus. These articles though do not take into effect the importance of speed. This article takes into effect the speed at which the changes are made in order to find the situations that cause a firm to make a change vs. when they are slower to make an adjustment. This study shows that a firm is significantly more likely to make a change when they have above target debit with a financial surplus or when they have below target debt and a financial deficit. This is different than what the previous studies showed because it considers the speed at which the adjustments were made indicating more incentive for the adjustment to be made by a firm.

3. Data Collection

The data used in this study is from the Annual Compustat files for the period of 1971 to 2003. Specifically, they focused on all firms that had positive values across the board. If a firm did not have positive values for total assets, book and market value of equity, and net sales then they did not include it in the study. This filter excluded approximately 8% of the firms from the annual compustat files.

In comparison to previous studies this study used total and long-term debt ratios measured with book and market value of total assets. In table II it shows the average total debt-to-book asset ratio and the average long-term debt-to-book asset ratio. With this data they were able to see that the average debt ratio is less in the later years of the data being utilized. Meanwhile in table III it shows summary statistics for the deficits and debt. Within the data that was utilized it shows that firms issue equity over debt in the later years.

4. Methodology

The first model that was used was a target adjustment model that is specifically created to allow for adjustment speed to be a part of the equation. This model shows that due to the differing speed of adjustments may represent a difference in cost of issuing debt vs equity. The second aspect of the model that was used is the Cash Flow Identity, which was used to show whether there was a surplus or a deficit and whether or either debt or equity needed to be added or subtracted. Table I shows the outcomes and what to expect for each circumstance when using the target adjustment model.

The second model that was used was a Financial deficit/surplus model. This model allowed for the study to see that firms were more likely to move toward a target capital structure if they had a surplus to reduce above target debt. vs low target debt. When using this model determining the target debt ratio which required a regression. They chose this in order to show the differences of what an ideal world would look like in comparison to the real world which has much more ups and downs.

5. Empirical Results

There were multiple tests done in this study to make sure that all the basis were covered and to see if what was being hypothesized was in fact true. In the results one should focus on a two main tables; table V, and table VII.

Table V shows the ordinary least squares results when utilizing equation number 2 in their paper. In this table it highlights that there are large differences between the simple regression for total debt and long-term debt as compared to when differential speeds of adjustment are included. These difference highlight that there is a relationship between speed of adjustment and above-target debt and below-target debt. It shows that when a firm has above-target debt their adjustment speed is much faster than when a firm has below-target debt.

Table VII shows the estimated equations numbers 5 and 6 utilizing the MEM approach. This table shows that firms with a deficit will increase debt while firms with a surplus will decrease debt. The table also shows that firms with above-target debt and a financial surplus will decrease their overall debt much more than when they are facing a financial deficit. It also states that firms with below-target debt will issue a greater amount of debt in relation to their total assets while in a deficit when compared to how they act in a surplus.

These results do not surprise me as it makes sense that a firm with above-targeted debt and who is currently experiencing a financial surplus would be more likely to decrease their debt. When a firm is in debt that is higher than they targeted for and they have surplus funds I would assume that they are utilizing those funds to decrease their debt which is what this proves. A firm never wants to be in too much debt so when they can reduce it, they will.

6. Conclusions

The study found that most adjustments occur when firms have above-target debt with a financial surplus or below-target debt with a financial deficit. Therefore, financial deficit or surplus has a significant influence on capital structure changes, yet in a different way then what was originally discussed with the traditional pecking order theory. This is important for someone in finance because it takes into consideration speed as a variable which sheds a new light on the topic when compared to the traditional pecking order theory. It shows that when speed of the adjustment is considered it changes the results and how firms approach capital structure adjustments.

If I were to replicate this study and write a similar article, I would increase the amount of data being used and only use more recent data. This study used data from 1971 to 2003 from only one database. While that database is extremely large, I would have tried to narrow down the time frame to the most recent 15 years available and attempted to pull data from a couple more sources including internationally in order to see if that would differ the results at all.


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