Investigation of the most appropriate capital structure theory and leverage level determinants
Lew, Sung Hee
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This thesis examines capital structure theories and debt level determinants to develop a better understanding, and to establish the most appropriate theory to explain the behaviour of firms‟ debt and equity choices. It tests three major capital structure theories (e.g. the trade-off, pecking order and market timing theories) using static and dynamic statistical models and 13 capital structure determinants, based on three major capital structure theories. The study uses 4,598 sample companies from 11 countries and 27 industries over a 20 year period. This method provides a clear insight into firms‟ debt and equity choice behaviours. The static trade-off theory is tested by first searching for similarities and differences between industries, countries and time periods and, second, by observing whether firms change their capital structures towards optimal levels and whether the coefficient signs are the same as the predictions. The "stock price effect‟ on debt levels is used to examine the pecking order and market timing theories. The pecking order theory is likewise tested by confirming whether firms issue debt when they face a financial deficit. Furthermore, these theories are tested using cluster analyses. The sample examines 11 different characteristics, which include firm size, debt level, and bankruptcy probability. As each characteristic is related to one or more capital structure theories, the most appropriate theory can be derived, based on such characteristics. There are five main findings. First, firms which are financial stable issue relatively more debt. Second, they have a preference for moderate debt levels and thus limit their bankruptcy probability. They also try to exploit opportunities from overestimated stock price by issuing stocks to increase cash inflows. Third, the effects from bankruptcy costs are greater than transaction costs in terms of capital structure adjustment. Fourth, during the sample period, firms continuously decrease leverage levels. Fifth, firms‟ characteristics and macro-economic factors affect their capital structure. There are three main conclusions. First, the behaviour of firms appears generally aligned with the trade-off theory, although the pecking order and market timing theories also partially explain the equity issuance condition. Second, the "equity and debt choice modes‟ can likewise be explained by the use of a theoretically combined approach, using the three major capital structure theories. In this approach, firms increase their value by both increasing debt for tax benefits and low adverse selection costs, and by issuing equity when the stock price is high. Third, this second conclusion implies that the trade-off, pecking order and market timing theories can be combined on the assumption that firms maximise their values under conditions of the existence of asymmetric information, tax shields and bankruptcy probability.