FINANCIAL ECONOMICS

Financial Economics

Abstract

This paper provides new evidence of how macroeconomic conditions affect capital structure choice. We model firms' target capital structures as a function of macroeconomic conditions and firm-specific variables. We split our sample based on a measure of financial constraints. Target leverage is counter-cyclical for the relatively unconstrained sample, but pro-cyclical for the relatively constrained sample. Macroeconomic conditions are significant for issue choice for unconstrained firms but less so for constrained firms. Our results support the hypothesis that unconstrained firms time their issue choice to coincide with periods of favorable macroeconomic conditions, while constrained firms do not. To identify this relationship, I study the erect on firms' financial structures of two changes in bank funding constraints: the 1961 emergence of the market for CDs, and the 1966 credit crunch. Following an expansion (con- traction) in the availability of bank loans, leverage ratios of bank-dependent firms significantly increase (decrease) relative to firms with bond market access. Con- current changes in the composition of financing sources lend further support to the role of credit supply and debt market segmentation in capital structure choice.

Financial Economics

Introduction

Capital structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities. A firm's capital structure is then the composition or 'structure' of its liabilities. For example, a firm that sells $20 billion in equity and $80 billion in debt is said to be 20% equity-financed and 80% debt-financed. The firm's ratio of debt to total financing, 80% in this example, is referred to as the firm's leverage. In reality, capital structure may be highly complex and include tens of sources. Gearing Ratio is the proportion of the capital employed of the firm which come from outside of the business finance, e.g. by taking a short term loan etc.

The Modigliani-Miller theorem, proposed by Franco Modigliani and Merton Miller, forms the basis for modern thinking on capital structure, though it is generally viewed as a purely theoretical result since it assumes away many important factors in the capital structure decision. The theorem states that, in a perfect market, how a firm is financed is irrelevant to its value. This result provides the base with which to examine real world reasons why capital structure is relevant, that is, a company's value is affected by the capital structure it employs. These other reasons include bankruptcy costs, agency costs, taxes, information asymmetry, to name some. This analysis can then be extended to look at whether there is in fact an optimal capital structure: the one which maximizes the value of the firm.( Myers, 1984, 189)

Capital structure in a perfect market

Assume a perfect capital market (no transaction or bankruptcy costs; perfect information); firms and individuals can borrow at the same interest rate; no taxes; and investment decisions aren't affected by financing decisions. Modigliani and Miller made two findings under these conditions. Their first 'proposition' was that the value of a company is independent of its capital ...