Understanding the Roles of the Market-to-Book Ratio and
Profitability in Corporate Financing Decisions∗
Long Chen
Department of Finance
Michigan State University
[email protected]
(517) 353-2955
Xinlei Zhao
Department of Finance
Kent State University
[email protected]
(330) 672-1213
First version: April, 2003
This version: February, 2004
Abstract
It is well documented that the market-to-book ratio and profitability are two key capital
structure determinants. However, because the related empirical evidence can be explained by
both the tradeoff theory and the costly external financing theory (which includes both the
pecking order theory and the market timing hypothesis), a large controversy remains in the
finance literature regarding the economic interpretation of these variables. This study focuses
on scenarios where the two theories have drastically different or even opposite predictions about
these variables. In each case, we find strong evidence in support of the costly external financing
theory but inconsistent with the tradeoff theory. We conclude that firms with higher marketto-book ratios are more likely to issue equity not because they intend to downwardly adjust
their target leverage ratios, but because they face lower external financing costs. Similarly,
firms with higher profitability are more likely to issue debt, not because they intend to move
toward their target leverage ratios, but because they face lower debt financing costs. These
conclusions remain firm with extensive robustness checks, alternative variable measures, and
different sample choices.
JEL Classification: G32
Key Words: Capital structure, tradeoff theory, pecking order theory, market timing hypothesis,
market-to-book ratio, profit, external financing costs, bankruptcy risk.
∗
We are grateful to Raj Aggarwal, Laurence Booth, Murillo Campello, Charles Headlock, Murray Frank, Jun-Koo
Kang, Naveen Khanna, Kai Li, John Thornton, Sheridan Titman, Ivo Welch, and seminar participants at Michigan
State University for their very helpful comments. We are responsible for all remaining errors.
1
Introduction
The market-to-book ratio and profitability assume prominent roles in corporate financing decisions.
It is well known that firms with higher market-to-book ratios or profitability have lower leverage
ratios. When resorting to external financing, those with higher market-to-book ratios are more
likely to issue equity, while those with higher profitability are more likely to issue debt. Despite
general agreement on these empirical regularities, the literature has witnessed an increasingly heated
debate on the economic interpretations of these two factors. This controversy arises because these
patterns can be alternatively explained by two competing schools of thought in the capital structure
literature.
The first school, namely the tradeoff theory, states that firms choose the optimal capital structure by balancing the tax and incentive benefits of debt financing and expected bankruptcy costs.1
According to this theory, firms with higher market-to-book ratios also have higher growth opportunities (e.g., Hovakimian, Opler, and Titman (2001)), and they intend to keep lower current target
leverage ratios in order to mitigate the underinvestment problem when future opportunities arise
(Myers (1977)). They are thus more likely to issue equity when they realize new investment opportunities and downwardly adjust their target leverage ratios. In addition, due to transaction costs
(Fischer, Heinkel, and Zechner (1989)), firms with higher profitability will passively accumulate
internal funds and are, on average, under-levered, which explains the negative relationship between
profitability and leverage ratios. When they resort to external financing, they are more likely to
issue debt in an effort to move toward their target ratios (Hovakimian et al. (2001)). As a result,
profitability cannot explain the post-financing leverage ratio because the passive role of profitability
has been corrected (Hovakimian, Hovakimian, and Tehranian (2003)).
The second school, which we call the costly external financing theory, consists of the pecking
order theory and the market timing hypothesis. The pecking order theory assumes that, because
of asymmetric information, external financing costs are higher than internal financing costs and
the relative costs are a major factor affecting corporate financing decisions.2 The market timing
phenomenon can arise either due to a dynamic version of the pecking order theory, where adverse
1
The tradeoff includes, among others, tax benefits versus bankruptcy costs (Modigliani and Miller (1963)), agency
costs of debt and equity financing (Jensen and Meckling (1976), Myers (1977), Stulz (1990), Hart and Moore (1995),
and Zwiebel (1996)), and signaling models (Ross (1977)).
2
In a strict version of the theory (Myers (1984) and Myers and Mujluf (1984)), it is assumed that the costs
of external financing are higher than those of internal financing, and the costs of equity financing are higher than
those of debt financing. These costs are so high that they outweigh other considerations. As a result, we observe a
pecking order preference of internal funds, debt, and equity financing. In a dynamic version of the theory, Lucas and
McDonald (1990) show that managers have private information on firm value, and can issue equity when stock price
rises to or above the true value.
1
selection costs vary through time and across firms, or due to the possible existence of mis-pricing
that changes the costs of equity financing and breaks the pecking order (Baker and Wurgler (2002)).
The common feature of the pecking order theory and the market timing hypothesis is their emphasis
on the role of external financing costs in capital structure decisions.3
The market-to-book ratio and profitability have been major sources from which the costly
external financing theory draws inspiration to interpret capital structure decisions. According to
this theory, firms with higher market-to-book ratios are more likely to issue equity because a higher
market-to-book ratio signals a lower cost of external equity financing.4 This view of market-to-book
ratio has been the main basis for a formal argument of the market timing hypothesis (Baker and
Wurgler (2002)). Welch (2004) shows that the driving force of leverage ratios is market valuation
of equity. Firms do not put countermeasures into effect to offset changes in these leverage ratios
that stem from variations in market valuations. In fact, when resorting to external financing, firms
with more favorable equity market valuations are more likely to issue equity, thus further deviating
away from their original leverage ratios. This evidence is consistent with the notion that firms
care more about external financing costs than their target leverage ratios. In addition, firms with
higher profitability consciously (instead of passively) prefer internal to external funds to avoid the
external financing costs, leading to a negative relationship between profitability and the leverage
ratio. The significant role of profitability has been argued as the strongest evidence in support of
the costly external financing theory (Fama and French (2002)).
Therefore, a proper understanding of the roles of the market-to-book ratio and profitability is
not only important for its own sake, but also critical for assessing the validity of the two major
competing theories. Unfortunately, because the relevant empirical patterns can be simultaneously
explained by the two schools of thought, current literature is more successful in establishing the
prominence of these variables than in explaining why they are important. In many of the related
studies, we can substitute the proposed explanation regarding the two variables with the opposing
theory and reach an entirely different conclusion.5
3
Throughout the paper, the term external financing costs refers to the fact that the costs of raising funds externally
are different from (usually higher than) the costs of internal funds. This difference could be due to the adverse selection
costs and it can be changed if there is market mis-pricing.
4
In particular, Myers and Mujluf (1984) point out that firms are more likely to issue equity when the external
financing costs fall. Choe, Masulis, and Nanda (1993) argue that the pro-cyclical equity issue can be explained by
the counter-cyclical external financing costs. Bayless and Chaplinsky (1996) document that during periods of higher
equity issuance the magnitude of costs due to asymmetric information is lower. Korajczyk and Levy (2003) show
that financially constrained firms exhibit dramatically different patterns of capital structure choice from financially
unconstrained firms, where the source of this difference, according to the imperfect capital market theory, is the
asymmetric information.
5
For example, Hovakimian et al. (2003) study dual issue versus pure equity issue. They argue that, because both
groups can issue equity, the market timing ability is controlled, and whatever role is left for the market-to-book ratio
2
We confront this challenge by studying scenarios where the two theories present drastically
different or even opposite predictions regarding these two variables. This approach provides the
opportunity to identify the true reasons behind the two variables. It also directly echoes Harris and
Raviv’s (1991) argument that advocates designing tests to study capital structure determinants
under different circumstances.6 Specifically, we focus on the following three scenarios:
(1) The tradeoff theory predicts that the market-to-book ratio only matters for firms with
medium bankruptcy risks and close-to-target leverage ratios (see text for a formal argument).
Similarly, the tradeoff theory predicts that profitability is only important for low bankruptcy risk,
under-levered firms, and is unimportant for others. In contrast, the costly external financing theory
does not emphasize the role of target leverage ratio, and thus predicts equal importance of the two
variables for all types of firms.
(2) The tradeoff theory predicts that firms with higher market-to-book ratios will never issue
additional debt on a net basis, because it does not help to reduce the target ratios. On the contrary,
if a higher market-to-book ratio signals lower external financing costs for both equity and debt,
then the costly external financing theory predicts that firms with higher market-to-book ratios are
not only more likely to issue equity, but also debt, or both.
(3) The tradeoff theory argues that the market-to-book ratio matters because it represents
new growth opportunities. The role of the market-to-book ratio should therefore diminish after
controlling for these growth opportunities. By contrast, the costly external financing theory does
not necessarily emphasize growth opportunities, and thus predicts that the impact of the marketto-book ratio persists even after controlling for growth opportunities.
In every scenario, we find consistent and strong evidence that the roles of the market-to-book
ratio and profitability favor the costly external financing theory, but are incompatible with the
tradeoff theory. In particular, firms with higher market-to-book ratios are significantly more likely
to access the external markets, including issuing equity only, debt only, or both. This pattern holds
regardless of the firms’ positions relative to the target leverage ratios, and even after controlling
for the growth opportunity variables. It is only when comparing equity to debt, that firms with
higher market-to-book ratios are more likely to issue equity. However, this preference for equity
must represent the growth opportunity, as predicted by the tradeoff theory. However, if we alternatively assume that
firms issuing equity have different abilities to time the market, then the role of market-to-book ratio will represent
this differential ability, and a different conclusion will be reached.
6
Harris and Raviv (1991) comment that empirical studies “have identified a large number of potential determinants
of capital structure. The empirical work so far has not, however, sorted out which of these are important in various
contexts....With regard to further empirical work, it seems essential that empirical studies concentrate on testing
particular models or classes of models in an attempt to discover the most important determinants of capital structure
in given environments.”
3
is unlikely to be driven by growth opportunities. This is because, when growth opportunities are
measured by variables other than the market-to-book ratio, we find a stronger reliance on debt
(rather than equity) financing for firms with high growth opportunities. These results suggest that
firms with higher growth opportunities make financing decisions based mainly on the relative costs
of debt versus equity issues. Firms with higher market-to-book ratios are more likely to issue equity
simply because a higher market-to-book ratio signals relatively lower equity financing costs. There
is no evidence indicating that firms intend to downwardly adjust their target ratios following better
growth opportunities, as proposed by the tradeoff theory.
Similarly, we find two pieces of evidence that clearly contradict the prediction by the tradeoff
theory regarding the role of profitability. First, firms with higher profitability are more likely to
issue debt regardless of whether or not they are under-levered. Second, the group predicted by
the tradeoff theory to exhibit the strongest influence from profitability (i.e., low bankruptcy risk,
under-levered firms) is usually much less active in issuing debt than other groups do. Therefore,
the role of profitability seems to be more related to the external financing costs of debt than to the
move-toward-the-target argument. All main conclusions in this paper hold steadily after extensive
robustness tests, alternative variable measures, and different sample choices.7
This paper thus contributes to the literature by providing fresh insights into the roles of the
market-to-book ratio and profitability. Without a clear understanding of these variables, doubts
may be cast on some recent interpretations of capital structure (e.g., the market timing hypothesis
by Baker and Wurgler (2002), and firms’ lack of countermeasures by Welch (2004)), because it
seems that the related empirical regularities can also be well explained by the tradeoff theory. Our
work demonstrates that, to a large extent, the roles of the market-to-book ratio and profitability go
far beyond the interpretation of the tradeoff theory, thus rendering support to the costly external
financing theory.
The rest of the paper proceeds as follows. Section 2 discusses theoretical predictions, on the
basis of which testable hypotheses are formed. Section 3 describes the data and analyzes firm
characteristics. Sections 4 and 5 provide univariate and regression-based analysis, respectively.
Second 6 discusses robustness checks, and a brief conclusion is provided in Section 7.
7
One possible concern is that the target ratios are estimated with noise. We believe this cannot affect our
conclusions in a significant way for the following reasons. First, we use eight alternative target ratio measures, all
of which lead to the same conclusions. Second, our analysis indicates that over-levered firms are riskier and are
significantly more likely to issue equity and retire debt than under-levered firms do. Thus it is hard to argue that
all firms are content with their current leverage ratios. Yet, the conclusions in this paper are robust across different
groups of firms.
4
2
Theoretical predictions and structure of the paper
The roles of the market-to-book ratio and profitability can be explained by both schools of thought.
Unless we study scenarios where the two theories have different predictions about these variables,
there seems to be little hope of identifying which theory is more relevant. In this section, we discuss
three experiments that might separate the predictions from the two theories, in an effort to shed
light on the roles of the two variables.
Partitioning firms according to their bankruptcy risks The tradeoff theory argues that
firms with higher market-to-book ratios are more likely to issue equity because they realize new
growth opportunities and thus issue equity to downwardly adjust the target leverage ratios. Such
an argument only applies to firms with leverage ratios reasonably close to their targets. Specifically,
imagine a high bankruptcy risk and over-levered firm issuing equity. Two alternative interpretations
may be offered: (1) the firm wants to raise funds and reduce the leverage ratio (toward the target),
and (2) the firm downwardly adjusts the target leverage ratio due to new opportunities. Given
that the firm has a high bankruptcy risk and is over-levered, the former explanation is probably
more reasonable than the latter.8 Similarly, imagine a low bankruptcy risk and under-levered firm
issuing equity. Since the firm is already under-levered, if the target leverage ratio falls due to the
new investment opportunity, the firm should do nothing (instead of issuing equity) and let the
target ratio fall naturally to the current leverage ratio. Hence, if the tradeoff theory is pertinent,
we should find that the market-to-book ratio is critical only for firms around the target, but not
vital for firms away from the target.
On the other hand, the costly external financing theory argues that firms with higher marketto-book ratios enjoy more favorable external equity financing costs, which holds regardless of the
target ratios. This theory thus predicts that firms with higher market-to-book ratios are more
likely to issue equities across all groups of firms regardless of their deviation from the target ratios.
Similar logic applies to the role of profitability. According to the tradeoff theory, firms with
higher profitability are on average under-levered (Hovakimian et al. (2001)), and thus issue debt
to move toward their target ratios (Hovakimian et al. (2003)). If this argument is true, then we
should expect profitability to be important only for under-levered firms, and not significant for
other groups (especially those high bankruptcy risk and over-levered firms). In contrast, the costly
external financing theory believes that firms with higher profitability are more likely to issue debt
8
If the over-levered firm issues equity to reduce the target leverage ratio instead of moving toward the target, then
the firm remains over-levered after the equity issue, which contradicts the prediction by the tradeoff theory.
5
probably because the costs of debt financing are relatively cheaper (compared to equity). Therefore,
this theory expects the role of profitability to be important for all groups of firms, regardless of
their deviation from the targets.
The above discussion implies that if we separate firms into groups according to bankruptcy
risks (deviation from the targets), the two theories will have drastically different predictions across
these groups regarding the roles of the two variables.9
Investigating equity as well as debt issues The tradeoff theory argues that firms with higher
market-to-book ratios issue equity because they have better growth opportunities and want to
retain the flexibility by downwardly adjusting the target ratios. It thus follows from the tradeoff
theory that firms with higher market-to-book ratios will never issue debt on a net basis, because net
debt issuance would raise the leverage ratios, which is contradictory to the target-ratio-adjustment
argument. In contrast, if higher market-to-book ratios signal lower external financing costs for both
debt and equity, then the costly external financing theory predicts that firms with higher marketto-book ratios are more likely to issue not only equity, but also debt, on a net basis. Therefore, the
two schools of thought have opposite predictions in the case of debt issue.
Hypotheses related to growth opportunities The tradeoff theory argues that a firm with a
higher market-to-book ratio realizes new investment opportunities and issues equity on a net basis
to downwardly adjust the target ratio. On the other hand, the costly external financing cost theory
argues that a firm with a higher market-to-book ratio is more likely to issue equity because it faces
relatively lower costs of external equity financing. These lower costs could be due to lower adverse
selection costs, or market mis-valuation that is not part of the future growth opportunities (Baker
and Wurgler (2002)). The above discussion leads to the following testable hypotheses:
• If the growth opportunities are the only reason why firms with higher market-to-book ratios
issue equity, as argued by the tradeoff theory, the market-to-book ratio should be of minimal
importance for firms with poor growth opportunities. In addition, the impact of the marketto-book ratio should diminish after controlling for growth opportunities. In contrast, the
costly external financing theory argues that firms choose to issue equity because of more
favorable equity financing. Thus the effect of the market-to-book ratio will persist even for
firms with poor growth opportunities and even after controlling for growth opportunities.
9
As we shall see shortly, sorting firm according to bankruptcy risk is very similar to sorting them according to the
deviation from the target ratio. We do not sort firms by the deviation from the target ratio directly because we do
not want to rely too much on the accuracy of the estimation of the target ratios.
6
• The costly external financing theory predicts that firms with higher growth opportunities
(when measured by variables other than the market-to-book ratio) could either be indifferent
between debt and equity financing, or even prefer the former to the latter. This is because
higher growth opportunities are not necessarily linked to lower equity financing costs. The
tradeoff theory, on the other hand, predicts that firms with higher growth opportunities
always prefer equity to debt because it lowers the target leverage ratios.
In summary, we have discussed a list of testable hypotheses, some of which are summarized in
Table 1. In each case, the two theories put forward very different predictions regarding the effects
of the market-to-book ratio and profitability on financing decisions. The rest of this paper will
explore the roles of the two variables along these lines. We restrain from drawing conclusions until
we reach a consensus from all tests.
3
3.1
The sample and firm characteristics
The sample
Definitions of all variables are provided in Appendix A. We use Z-score, a measure developed by
Altman (1968), to gauge a firm’s bankruptcy probability.10 This is arguably the most popular
measure used in the capital structure literature (e.g., Mackie-Mason (1990), Graham (1996), and
Frank and Goyal (2003 B)) to capture the probability of financial distress. A higher Z-score
represents a lower bankruptcy probability.
The financial accounting data are from COMPUSTAT’s P/S/T and Research annual industrial
tapes from 1971 to 2001.11 All dollar values are converted into 1983 constant dollars. Following the
tradition in the capital structure literature, we delete financial firms (6000-6999), firms involved in
major mergers (COMPUSTAT footnote code AB), and firms that reported format code 4, 5, or
6. The equity return data are from the Center for Research in Security Prices (CRSP) where we
require that firms have two years’ return data available. We also require the availability of data
on long-term debt issuance or reduction (Items 111 or 114), and purchase or sales of stocks (Items
115 or 108). We delete observations with equity repurchases and pure debt reductions, for reasons
we will explain later. We are left with 90,264 observations after this step. The requirement of
additional variables in the estimation of firm target ratios, and grouping of firms based on lagged
10
Using multiple discriminant analysis, Altman (1968) shows that a combination of factors such as liquidity (working
capital / assets), cumulative profitability (retained earnings / assets), productivity (earnings before interest and tax
/ assets), capital-turnover ratio (sales / assets), and leverage ratio (market value of equity / book value of debt) can
predict more than 90% of corporate failures. A linear combination of these variables is used to create Z-score.
11
The flow of fund data are available in COMPUSTAT from 1971.
7
Z-scores further cut the sample to 53,944 observations during the period of 1972-2001.12
3.2
Firm characteristics
We separate firm-years into quintiles according to Z-scores. General firm characteristics are summarized in Panel A of Table 2 with the following patterns. By construction, Z-score increases
monotonically from Group 1 to 5, indicating a decreasing bankruptcy risk. The grouping is unlikely to be subject to industry bias because the industry adjusted Z-score, defined as the Z-score
adjusted for its industry-year median, follows the same pattern. Higher bankruptcy risk firms have
lower sales growth (as a measure of growth opportunity), lower profitability, and higher net operating losses carryforward. They are accordingly penalized in the financial markets as suggested by
their lower equity returns. Consistent with the notion that higher bankruptcy risk firms also have
lower growth opportunities, these firms also have lower market-to-book ratios. Lower advertising
expenses and higher tangibility further suggest that Group 1 firms are mainly from the mature
industries.
One important factor of the costly external financing theory is the availability of internal funds.
Panel B of Table 2 provides evidence addressing this issue. Interest coverage ratio monotonically
increases, from 1.56 in Group 1 to 16.53 in Group 5, which implies that, relatively speaking, firms
with higher bankruptcy probability need greater amounts of additional funds for debt services.
A monotonically growing trend of cash holding can also be seen from Group 1 to 5. Therefore,
firms with higher bankruptcy probability not only need more additional funds, but also have more
restricted sources of internal funds.
Naturally, we expect firms in higher demand for additional funds to be forced to make tighter
decisions on their uses of funds. Indeed, capital expenditure monotonically increases from -5.62
% in Group 1 to 15.08% in Group 5.13 Inventory also exhibits a rising trend from Group 1 to
3. Despite these tighter expenditure decisions, higher bankruptcy risk firms face higher financial
deficits, which summarizes the gap between internal funds generated from operation and investment
activities (excluding cash) and the amount needed to finance capital expenditure, dividend payout,
and other business activities (e.g., Frank and Goyal (2003 A)). Financial deficit decreases from
Group 1 (3.31%) to Group 5 (0.04%).
12
We delete observations whose accounting variables used in this study have missing codes (0.001 to 0.009). We
exclude outliers whose Z-scores are three standard deviations away from the mean. The right cut-off point for the
market-to-book ratio is three standard deviations away from the mean, and the left cut-off point for the variable is
zero. The cut-off points for intangible assets, collaterals, and the leverage measures are zero at the left and one at
the right.
13
We use the industry-adjusted capital expenditure in order to control for the difference in capital expenditure
behavior across different industries.
8
Finally, we present leverage ratio characteristics. To ensure robustness, we use four measures
of leverage ratio: total debt over market value of asset (TDM), long-term debt over market value
of asset (LDM), total debt over book value of asset (TDA), and long-term debt over book value of
asset (LDA). In addition, central to the tradeoff theory is the target leverage ratio. We use two
relevant measures. The first estimate of the target ratio is the annual industry median leverage
ratio. The second measure, similar to Hovakimian et al. (2001), is the fitted value of the following
regression:
T LEVit = Xit−1 × β + εit ,
(1)
where T LEVit is the target leverage ratio, β is the vector of coefficients, and Xit−1 is a vector of
the capital structure determinants. Because of their familiarity in the literature, we report the
estimation results for the target ratio in Appendix B and Table A-1. The estimated coefficients are
then used to calculate the fitted target ratio for each firm-year.
We are now in a position to investigate the leverage patterns of firms partitioned by their
bankruptcy probability. In Panel C of Table 2, under all four leverage ratios and two target ratio
measures, there is a monotonically decreasing (increasing) trend in leverage (deviation from the
target) from Group 1 to 5. In particular, Groups 1 and 2 seem to be clearly over-levered, and
Groups 4 and 5 appear to be under-levered. Note that Group 5 firms, which include the top 20%
of all firms, have extremely low leverage ratios (less than 5%), in spite of the fact that they are
very profitable. Hence, it seems safe to conclude that these firms are under-levered even though
estimation errors may exist. These numbers are all significant at the 1 percent level, due to the
large sample size.
What we have established from the firm characteristic analysis can be summarized as follows.
First, firms with higher bankruptcy probability are riskier in the following sense. They have lower
sales growth and profitability, suffer operational losses, and are penalized in the equity market.
Second, as the bankruptcy risk increases, firms’ needs for external funds also rise. Firms with
higher bankruptcy risks have, on average, lower interest coverage ratios and cash holding, and
higher financial deficits. They seem to be forced to have lower inventory and capital expenditure.
Third, our grouping of firms along the dimension of the bankruptcy risk appears to be perfectly
in harmony with grouping based on the deviation from the target. High bankruptcy probability
firms seem to be over-levered and low bankruptcy probability firms appear to be under-levered.
These leverage characteristics across the Z-score groups are robust under alternative leverage ratio
measures. Across these Z-score groups, the tradeoff theory and the costly external financing theory
have drastically different predictions with regard to the importance of the market-to-book ratio
9
and profitability in corporate financing decisions, the subject on which we shall now focus.
4
Univariate results
4.1
Financing types
Following Hovakimian et al. (2001) and Korajczyk and Levy (2002), an equity issue is identified
if a firm’s net equity issue (Item 108 - Item 105) divided by the book value of asset exceeds 5%.14
Debt issue (reduction) is similarly defined by tracking the proportional change of total debt (Item
111 - Item 114).15 We identify 5 types of financing decisions related to capital structure changes:
• Type 1: Issue both equity and debt within the same year
• Type 2: Issue debt only
• Type 3: Issue equity only
• Type 4: Do nothing
• Type 5: Issue equity and reduce debt
An explanation is needed for Type 4, do nothing, which is usually ignored by earlier studies.
The tradeoff theory predicts that if firms are over-levered (under-levered), they will make efforts
to cut (increase) leverage. In contrast, the costly external financing theory argues that, regardless of current leverage, firms with more internal cash flows are more likely to avoid the external
markets and do nothing, and the propensity to do nothing declines with the external financing
costs. Therefore, investigation of those firms doing nothing also sheds light on the capital structure
theories.16
4.2
4.2.1
Univariate analysis
The role of the market-to-book ratio
Motivated by the theoretical predictions, we separate firms into 25 groups according to their
bankruptcy risks and market-to-book ratios (5 by 5), and study their capital structure decisions.
The results, reported in Table 3, reveal the following interesting patterns:
14
For robustness, we also changed the selection standard to 3% (instead of 5%). The main results in this paper are
very persistent.
15
Both aforementioned studies find that these issue classifications are comparable to using the SDC new issue
dataset when data are available.
16
In addition, we exclude firm-year observations involving stock repurchases because repurchases may be driven by
concerns other than capital structure considerations (e.g. corporate control, reservation for stock option conversions,
etc.). We also exclude observations with pure debt reduction because these do not seem to be directly related to the
market-to-book ratio and profit, the key subject in this study.
10
First, the tradeoff theory predicts that the role of the market-to-book ratio will be material
for the equity issuance decisions for firms with medium bankruptcy risks and around-the-target
leverage ratios, but weak for other groups. In contrast, we find that the market-to-book ratio is
important for all groups of firms. For example, Panel E includes the top 20% firms that have the
lowest bankruptcy risks and are clearly under-levered (with raw leverage ratio less than 5%). If
these firms realize new investment opportunities, they should let the target ratio naturally fall to the
current leverage ratio instead of issuing new equities because they are under-levered. Nevertheless,
Panel E exhibits a strong increasing trend of pure equity issue as the market-to-book ratio grows:
from 1.29% for the first market-to-book ratio quintile, to 18.26% for the fifth market-to-book ratio
quintile. This rising trend is monotonic among the groups in Panel E, and the differences, according
to the proportion tests, are significant at the 5 percent level.
Similarly, for firms with the highest bankruptcy risks (Panel A), the propensity to issue equity
also increases with the market-to-book ratio. It is difficult to reconcile this pattern with the growth
opportunity argument by the tradeoff theory because Panel A includes firms with poor growth
opportunities, as suggested in Table 2, and this argument predicts that the market-to-book ratio
should be of minimal importance to these firms. Furthermore, as we have argued in Section 2, it
is awkward to apply the target-ratio-adjustment scenario to these over-levered firms.
The pattern of equity issuance is the same for all five panels, regardless of the bankruptcy risk
(deviation from the target), and the patterns seem to be even stronger for firms with low or high
bankruptcy risks than those with medium bankruptcy risks. In addition, the same pattern across
different market-to-book ratio groups also holds for equity issue/debt reduction types, except that
the pattern gets stronger when the bankruptcy risk increases. These observations are not consistent
with predictions from the tradeoff theory as outlined in Table 1. Therefore, in a test where we can
separate the predictions from the tradeoff theory and the costly external financing theory, we find
strong support for the latter, but not the former.
Second, the tradeoff theory argues that firms with higher market-to-book ratios shall not issue
debt on a net basis, because debt issuance raises (instead of reduces) the leverage ratios. In contrast,
Table 3 shows that the propensity to issue debt generally increases with the market-to-book ratio.
For example, Panel B demonstrates that 18.47 percent of firms within the first market-to-book
ratio quintile participate in debt financing, and this number increases to 29.65 percent for the
fifth market-to-book ratio quintile. The same pattern can be seen for other panels and for dual
issues. Therefore, it appears that as the market-to-book ratio increases, firms are not only more
likely to issue equity only, but also debt only, or both. The statistical significance of these trends is
11
confirmed by the proportion tests as shown in the last two columns of the table. While the patterns
clearly violate the tradeoff theory, they seem to suggest that the market-to-book ratio is a proxy
for the external financing costs of both debt and equity. Hence, in a test where the tradeoff theory
and the costly external financing theory have opposite predictions, the latter clearly prevails.17
To summarize, with respect to the role of the market-to-book ratio, the tradeoff theory and
the costly external financing theory carry drastically different predictions about firms with different
combinations of bankruptcy risks and the market-to-book ratios. In all cases we find strong evidence
in favor of the costly external financing theory but not the tradeoff theory.
4.2.2
Alternative measures of growth opportunities
We have three sets of hypotheses that are related to the use of alternative growth opportunity
proxies. First, the tradeoff theory predicts that the market-to-book ratio and equity financing is
weak for firms with poor growth opportunities. The costly external financing theory predicts a
strong role of the market-to-book ratio even for these firms. Second, the tradeoff theory predicts
that, after controlling for growth opportunities, the relationship between the market-to-book ratio
and equity financing will diminish. The costly external financing theory, on the other hand, predicts
a persistent relationship even after controlling for growth opportunities. Third, the costly external
financing theory predicts that if higher growth opportunities are not fully captured by higher
market-to-book ratios, firms with higher growth opportunities but relatively lower market-to-book
ratios may not necessarily resort to external equity financing; they may even prefer debt financing.
By contrast, the tradeoff theory predicts that firms with higher growth opportunities will always
prefer equity to debt. In this subsection we test these hypotheses using two alternative measures of
growth opportunities: the sales growth rate and the capital expenditure.18 The results are reported
in Table 4.
In Panel A of Table 4, we first use the sales growth rate to represent growth opportunities,
and partition observations into quintiles along this dimension. We observe patterns compatible
17
Almazan, Suarez, and Titman (2003) develop a model where firms might prefer to attain conservative leverage
ratios to avoid the possible negative effect that external scrutiny levies on them. Following this logic, it can be argued
that firms with higher market-to-book ratio are already positively identified by the market, and thus are more willing
to raise the target leverage ratios. This thus has the potential to explain why firms with moderate leverage ratios
but relatively higher (lower) market-to-book ratios are more (less) likely to issue debt only, whereas the traditional
tradeoff theory predicts that firms with higher market-to-book ratios will never issue debt on a net basis. However,
this external scrutiny story can not explain the consistent debt financing pattern across all groups of firms, regardless
of whether or not they are under-levered.
18
We choose not to use R&D as the measure of growth opportunities because the use of this variable would
sharply reduce our sample size as a result of the limited data availability. Omission of this variable may cause
specific problems for high-tech industries that are R&D heavy. We address this problem by excluding the high-tech
industries in the robustness check section.
12
with the costly external financing theory. In particular, even for firms with relatively poor growth
opportunities (Panel A1), a strong mounting trend of equity financing is evident with the rise in
the market-to-book ratio. In addition, across all sub-panels and after controlling for the growth
opportunity variable, firms with higher market-to-book ratios are in general significantly more likely
to raise not only equity, but also debt, or make dual issues.
Furthermore, firms with higher sales growth rates exhibit stronger reliance on pure debt issues.
From Panel A1 to A5 and within the same market-to-book ratio quintile, there is a clear trend of
increasing reliance on pure debt financing. In comparison, we do not observe the same smooth trend
of equity financing when we move within the same market-to-book ratio quintile from Panel A1 to
A5.19 These patterns are consistent with the notion that, when accessing the external market, firms
with higher growth opportunities choose the type of financing that is relatively cheaper instead of
simply issuing equity to lower the target ratio.
It can be argued that the current sales growth is a result of past (instead of future) investment
opportunities and the firms have made necessary adjustments in their capital structure in the past.
To mitigate this concern, we replace the sales growth with the industry-adjusted capital expenditure
as the proxy for future growth opportunities. The rationale is that capital investments provide the
platform for growth in the future. The result is reported in Panel B of Table 4. We observe exactly
the same patterns as in Panel A.
Therefore, in each of the three sets of hypotheses related to growth opportunities, we find
evidence that clearly favors the costly external financing theory but that is inconsistent with the
target-ratio-adjustment argument put forward by the tradeoff theory.
4.2.3
The role of profitability
The tradeoff theory argues that firms with higher profitability are, on average, under-levered, and
tend to issue new debt to move toward the target (Hovakimian et al. (2001), Hovakimian et al.
(2003)). It follows from this argument that profitability should matter only for under-levered firms,
but not for other groups. The costly external financing theory, on the other hand, does not base
its interpretation on the deviation from the target, and thus predicts equal effectiveness of this
variable across different groups.
We directly test this pair of hypotheses in Table 5, where firms are sorted by their bankruptcy
risks and profitability. Two patterns emerge. First, firms with higher profitability are always more
19
For example, for firms with the highest market-to-book ratios, 22.72% of those with the lowest growth opportunities (Panel A1) are engaged in pure equity financing. The same number drops to 3.88% in Panel A2 and 4.09% in
Panel A3. The number climbs to 18.08% in Panel A5.
13
likely to issue debt, and this pattern is robust across all panels. This finding is not in harmony
with the tradeoff theory, because issuing pure debt will push high bankruptcy risk and over-levered
firms further away from the target. Second, a comparison across panels reveals that under-levered
firms (in Panel E) do not appear to have a higher propensity to issue debt than other firms do. For
example, among firms with the highest profitability, 16.71% of those with the lowest bankruptcy
risks (in Panel E) issue pure debt. This number monotonically increases to 40.43% for those with
the highest bankruptcy risks (in Panel A). In other words, a combination of the following two
patterns contradicts the predictions of the tradeoff theory: (a) profitability is important for all
groups; and (b) the group predicted by the tradeoff theory to exhibit the strongest influence from
profitability is least active in issuing debt. Therefore, movement towards the target does not seem
to be the main reason why high profitability firms issue debt.
Overall, the robust role of profitability across all five groups indicates that profitability matters not because firms intend to move toward their leverage targets; instead it seems that higher
profitability is in general related to lower debt financing costs.
In summary, we use univariate analysis to test a list of hypotheses where the tradeoff theory and
the costly external financing theory have different theoretical predictions regarding the roles of the
market-to-book ratio and profitability in capital structure decisions. In every scenario, we find clear
evidence in favor of the costly external financing theory but not the tradeoff theory. Specifically, it
seems that firms with higher market-to-book ratios face lower external financing costs. As a result,
they are more likely to access the external markets, including equity, debt, or dual issues. These
patterns hold even after controlling for growth opportunity variables. In addition, although firms
with higher market-to-book ratios prefer equity to debt, when growth opportunities are proxied
by variables other than the market-to-book ratio, firms with higher growth opportunities exhibit a
stronger reliance on debt than equity financing. This implies that firms choose the types of external
financing depending on their relative costs instead of on the basis of target ratio adjustment. Firms
with higher market-to-book ratios are more likely to issue equity simply because they face relatively
cheaper costs of equity financing. Furthermore, firms with higher profitability are more likely to
issue debt, not because they are under-levered and intend to move toward the targets, but probably
because of the relatively lower debt financing costs they face. We shall now address regression-based
analysis to see whether these patterns hold after controlling for other capital structure determinants.
14
5
Regression-based analysis
5.1
Multinomial logit regressions
We first conduct a multinomial logit regression involving all 5 financing types. In particular, we
use Type 4 (doing nothing) as the base case, and assume that financing decisions can be described
as
eβk ×(Levit −Levit−1 )+Xi,t−1 ×γk
=
P
∗
1 + k=1,2,3,5 eβk ×(Levit −Levit−1 )+Xi,t−1 ×γk
∗
Pik
(2)
∗ −
where Pik represents the probability of the ith firm-year falling into the kth financing type. Levit
Levit−1 measures the deviation from target, and Xt−1 are the other lagged explanatory variables.
Besides a list of general independent variables, we create five group-specific variables for the marketto-book ratio and profitability. In particular, we first separate firms into quintiles according to their
bankruptcy risks. For the market-to-book ratio and profitability respectively, we create five dummy
variables that are equal to the variable (either the market-to-book ratio or profitability) times a
dummy that is equal to one if the firm is within a particular bankruptcy risk group, and zero
otherwise. The intuition of this model specification is to allow the same variables to have different
impact on firms from different Z-score groups, in an effort to investigate their consistency with
the theoretical predictions in Table 1. The coefficients are estimated via the maximum likelihood
method, and are reported in Table 6 (coefficient estimates are reported in the first row and standard
errors are reported in parentheses in the second row).20 We will discuss the variables in turn.
General variables Compared to firms doing nothing, firms with higher deviations from the
target (meaning relatively less levered) are more likely to issue pure debt, pure equity, or both, and
are less likely to conduct equity issue and reduce debt at the same time. The patterns for pure debt
issue and equity issue/debt reduction are consistent with the tradeoff theory, whereas the pattern
for pure equity issue contradicts the theory’s predictions. The inconsistent role of the deviation
from the target is contradictory to Hovakimian et al. (2001), but compatible with Hovakimian
(2003).
Firms with higher stock returns in the past two years are significantly more likely to resort
to equity financing, including pure equity issue, dual issue, and equity issue/debt reduction. In
addition, smaller firms seem to be more likely to change their leverage ratios actively, and firms
that resort to external markets tend to have higher financial deficits. Finally, firms are more likely
to both issue and retire debt when the T-bill rates are significantly lower, and issue pure equity or
20
The regression results are very robust to alternative leverage ratio measures. Because of space limitation, Table
6 only reports the results using TDM and the fitted target ratio.
15
conduct dual issues when the T-bill rates are significantly higher. Because of the counter-cyclical
monetary policy conducted by the Federal Reserve, interest rates are higher during booms and
lower during recessions. Therefore, firms are more likely to issue equity during booms (e.g., Choe,
Masulis, and Nanda (1993) and Bayless and Chaplinsky (1996)), but are forced to issue debt, or
cutback the leverage ratio when the economy is in recessions.
Market-to-book ratio We find a strong role of the market-to-book ratio across all Z-score
groups. Firms with higher market-to-book ratios are significantly more likely to tap the external
markets, including pure equity issue, pure debt issue and dual issues. These firms also appear to
take advantage of the favorable equity financing costs to issue equity and retire debt. The fact that
firms with higher market-to-book ratios are also more likely to issue debt is not compatible with
the tradeoff theory.
Furthermore, the coefficients of the market-to-book ratio exhibit a monotonically increasing
trend from Group 5 to 1 for all financing types. Without reporting details, we find these trends to
be statistically significant from the Wald tests. This finding is inconsistent with the target-ratioadjustment argument by the tradeoff theory, which predicts the relationship to be important only
for equity issuance and only for firms around targets. In contrast, this finding agrees with the costly
external financing theory. Our earlier firm characteristic analysis indicates that, as bankruptcy risk
increases from Group 5 to 1, firms’ needs for external financing also rise. As higher market-to-book
ratios signal lower external financing costs, they become more precious for firms in higher demand
of external funds, which explains their stronger impact on higher bankruptcy risk firms.
Therefore, the market-to-book ratio plays a significant role in corporate financing decisions, but
it is hard to reconcile its role with the target-ratio-adjustment argument from the tradeoff theory;
instead it seems to agree more with the costly external financing theory.
The findings from the
multinomial logit regressions are consistent with those from the univariate analysis.
Profitability Compared to firms doing nothing, firms with higher profitability are more likely to
issue debt, whereas those with lower profitability are more likely to resort to external equities. The
patterns hold true across different Z-score groups after controlling for common capital structure
determinants.
If the move-toward-the-target argument is relevant, we should expect the profitability coefficients, in the context of pure debt issue, to be significant only for firms with low bankruptcy risks,
but insignificant for other firms. At the very least, we should observe a weakening trend in the
16
magnitude of this coefficient from Group 5 to 1. In contrast, we find that the coefficients are
statistically significant, and demonstrate an increasing trend from Group 5 to 2. The relationship
between profitability and pure debt issue thus cannot be explained by the move-toward-target argument put forward by the tradeoff theory. Instead, it is consistent with the idea that firms with
higher profitability might face lower external debt financing costs.
Again, the patterns we observe in the univariate analysis continue to be strong and significant
even after controlling for other capital structure determinants.
5.2
Logit analysis
We next use logit regressions to focus on pure debt versus pure equity financing decisions, which
has been studied extensively in current literature. We use pure equity issue as the base case (y=0)
and compare it with pure debt issue (y=1).21 We use the same set of explanatory variables as in
the multinomial logit analysis. The regression results with four alternative leverage ratio measures
are presented in Table 7. We discuss the variables in turn.
General variables Firms with higher deviation from the target (i.e., relatively less levered) are
less likely to resort to debt financing, which runs contrary to the tradeoff theory. As Hovakimian
(2003) argues, the significant role of the deviation from the target that is in line with the tradeoff
theory and documented in earlier studies (e.g., Hovakimian et al. (2001)) is primarily driven by
firms simultaneously issuing equity and retiring debt. Consistent with his findings, when we only
use pure equity versus pure debt decisions, we find evidence contradicting the tradeoff theory.
Firms with higher stock returns in the past two years are less likely to resort to debt rather
than equity financing. The multinomial logit regression suggests that this pattern is mainly driven
by the fact that these firms are much more likely to resort to equity financing (instead of debt
financing). Larger firms are more likely to issue debt instead of equity, and there is no significant
difference in financial deficits between debt versus equity issuing firms. Finally, firms are more
likely to issue debt instead of equity when the interest rate is lower. As we have discussed, the
economy is usually in a better state when the interest rate is higher, during which periods we also
21
In particular, we assume that financing decisions can be described in the following equation:
=
eβ×(Levit −Levit−1 )+Xt−1 ×γ
∗
1 + eβ×(Levit −Levit−1 )+Xt−1 ×γ
=
∗
Λ (β × (Levit
− Levit−1 ) + Xt−1 × γ) ,
∗
Pr (yit = 1)
(3)
where P r(yit = 1) is the probability a firm chooses one transaction type versus another at year t. Λ is the logistic
∗
function, Levit
− Levit−1 measures the deviation from target, and Xt−1 are the other lagged explanatory variables.
We study one pair of financing decisions: pure equity (y =0) versus pure debt financing (y =1).
17
observe more equity issues.
Market-to-book ratio and profitability We find in the multinomial logit regression that,
compared to firms doing nothing, firms with higher market-to-book ratios are more likely to issue
both equity and debt. The logit regressions imply that firms with higher market-to-book ratios
prefer equity to debt. This is consistent with the notion that a higher market-to-book ratio signals
lower costs of equity relative to debt.
A preference of equity to debt is in the direction of reducing leverage ratios. The target-ratioadjustment argument by the tradeoff theory thus predicts that the pattern should be strong for
firms around the target, but becomes weaker or insignificant for other firms. In contrast, we find
the variable to be important across all groups of firms. In addition, there is no evidence that the
role of the market-to-book ratio is stronger for the firms around the target than for other firms.
These patterns thus violate the tradeoff theory.
The logit regression also suggests that firms with higher profitability are significantly more
likely to issue debt instead of equity, which is in the direction of increasing leverage ratios. Earlier
analysis in the multinomial logit regression indicates that this is driven by two simultaneous trends
in different directions: firms with higher profitability are significantly more likely to issue debt, and
are significantly less likely to issue equity. Because the importance of profitability is robust across
all five bankruptcy risk groups, it cannot be explained by the move-toward-the-target argument.
Therefore, the evidence favors the costly external financing theory instead of the tradeoff theory.
In summary, our conclusions regarding the market-to-book ratio and profitability are robust in
the logit regressions, after controlling for common capital structure determinants.
5.3
Decomposition of the market-to-book ratio
The regression-based analysis thus far has tested two sets of hypotheses: separating firms by
bankruptcy risks (i.e., deviation from the target) and studying both equity and debt issues. In
this subsection we focus on the hypotheses related to growth opportunities. Instead of including
the growth opportunity variables in the regressions, we first conduct a decomposition of the marketto-book ratio. The idea is to separate the component of the market-to-book ratio that is related
to growth opportunities from the rest of the components. In particular, we run the following
18
industry-year regression:22
LogMBit = (α0 + α1 × Profitit + α2 × Leverageit ) + (α3 × Gsalesit + α4 × CAPXit ) + (εit ) , (4)
where LogMB represents the natural logarithm of the market-to-book ratio, Profit is the profitability variable, Leverage is TDA (total debt over total book assets), Gsales is the log sales growth
rate, and CAPX is the industry adjusted capital expenditure.
The regression is run for each industry year. We first separate all firms into 12 industries, as
defined by Fama and French (1997). Within each industry year, we run the above cross-sectional
regression. Using the estimated coefficients for each industry year, we decompose the market-tobook ratio into three components as separated by the brackets in the above equation.
The first bracket, (α0 + α1 × profitabilityit + α2 × Leverageit ), which we call the non-growth
component (N GROW T H), is the predicted part of the market-to-book ratio that is not directly
related to growth opportunities. The second bracket, (α3 × Gsalesit + α4 × CAPXit ), includes the
two variables we used earlier to measure growth opportunities, and we call this the growth component (GROW T H). Finally, the last bracket is simply the error term, which we call the firm-specific
component (F IRM ). It captures the part of market-to-book ratio that can not be explained. The
industry-by-industry, year-by-year estimation not only ensures that we are not subject to industry
bias, but also captures time variations in the two components of the market-to-book ratio that can
be explained by firm-specific variables. We report the estimation results in the appendix in Table
A-2.
After decomposition of the market-to-book ratio, we then rerun the multinomial logit and
logit regressions. We use the same general variables as before, with the following changes: (a)
We substitute the five market-to-book ratio variables by their decomposed components; and (b)
we add five change-of-growth variables, which are defined as the changes in the growth component
(GROW T Ht -GROW T Ht−1 ). The rationale behind the inclusion of the change-of-growth variables
is that the tradeoff theory believes that firms issue new equity because they realize new investment
opportunities, which the change-of-growth variables are meant to capture.
This exercise is not meant to prove that the market-to-book ratio is not related to growth
opportunities. Instead, we intend to show that growth opportunities are not the only reason why
the market-to-book ratio is significantly related to firm financing decisions. We discuss the results
from multinomial logit and logit regressions in turn. The results regarding the general variables
22
The method of decomposition follows the accounting literature (see Barth, Beaver, and Landsman (2001), Penman
(1998), and Collins, Maydew, and Weiss (1997)) and has been adopted in several finance studies (see Lee, Myers and
Swaminathan (1999), and Rhodes-Kropf, Robinson and Viswanathan (2003)).
19
and the profitability variable are very similar to those in Tables 6 and 7. For brevity, we only report
and discuss variables related to the components of the market-to-book ratio in Tables 8 and 9.
5.3.1
Multinomial logit regression
The following patterns can be summarized from Table 9. First, the firm component (F IRM ) is
positive and significant for all financing types and across all Z-score groups. This indicates that the
unexplained, error component of the market-to-book ratio has significant power in explaining firm
financing decisions. Firms with higher F IRM are significantly more likely to resort to external
financing, including pure equity, pure debt, dual issues, and issuing equity and retiring debt. This
seems to be in harmony with the market-timing hypothesis. In addition, firms with higher nongrowth components (N GROW T H) also follow the same patterns.
Second, firms with higher growth components (GROW T H) are more likely to resort to both
debt financing and external equity financing. The observation that firms with higher growth opportunities are not only more likely to issue equity, but also debt, is not predicted by the tradeoff
theory. In addition,the coefficients for the change-of-growth variables are usually not statistically
significant, and in cases where they are significant, they seem to imply that firms experiencing
higher growth opportunities sometimes issue equity, while at other times issue debt. These results are hard to interpret, but clearly they do not render support to the target-ratio-adjustment
argument.
5.3.2
Logit regression
The logit regressions focus on pure debt versus pure equity choices. Similar to the case of multinomial logit regression, the firm components and non-growth components are significant with
signs consistent with earlier results. In contrast, the growth component and the change-of-growth
variables in most cases are not significant. This finding is not compatible with the notion that
the growth opportunities are the main reason why the market-to-book ratio is related to firms’
debt/equity decision.
In summary, to investigate whether the explanatory power of the market-to-book ratio is due to
growth opportunities, we decompose the firm-specific market-to-book ratio into components that
are either related to growth opportunities or not. We find, through multinomial logit and logit
regressions, that the components that are not related to growth have persistent power across all
financing types and bankruptcy risk groups, while the components that are related to growth are
either relatively weaker or not significant. These results are consistent with our earlier finding that
20
the role of the market-to-book ratio in corporate financing decisions cannot be well explained by
the target-ratio-adjustment argument put forward by the tradeoff theory. Instead, the patterns are
more in line with the costly external financing theory.
6
Further robustness validation
We conduct extensive tests to ensure that our main conclusions are robust to alternative measures
of bankruptcy risks and leverage, and are not caused by improper measures of growth opportunities.
Due to space limitation, we summarize, without reporting, our attempts and findings here.23
The bankruptcy risk measure adjusted for industry bias The main ex ante bankruptcy
risk measure used is Z-score, which is not adjusted by industry. The Z-score sorting thus might
bear some industry bias (MacKay and Phillips (2002)). To dash this concern, we also use the
adjusted Z-score as our primary bankruptcy risk measure, where the adjusted Z-score is defined
as the Z-score adjusted by its industry median during that year. All major conclusions continue
to hold when the alternative measure is used. This is not surprising since Table 2 shows that the
Z-score and the adjusted Z-score follow the same patterns.
Alternative leverage ratio and target ratio measures We use four alternative measures of
leverage ratios, including TDM, LDM, TDA, and LDA, and when space permits, we report all of
them (such as in the logit regressions). In addition, we use two measures of target ratio: industrial
median or the fitted value of target. However, we only report results attained using the latter. Our
major conclusions hold regardless of which leverage ratio or target ratio measure is used.
Further control on the growth opportunity variables We conduct two additional checks
on these variables. First, it can be argued that neither sales growth nor capital expenditure may
be able to capture properly the growth potential of firms in high-tech industries. Including these
firms in the sample thus might lead to biased results in uncovering the relationship between growth
opportunities and financing decisions. To ensure robustness, we delete all firms in the high-tech
industries (industry 6, 7 and 10 in the 12 Fama and French (1997) industries). We then repeat the
univariate and regression-basis analysis. We find that the exclusion of high-tech industries does not
change the results we found earlier.
Second, we merge our sample with the I/B/E/S dataset that contains analyst forecasts of future
earnings. The sample size is reduced by roughly two thirds after this procedure. We try several dif23
All results are available upon request.
21
ferent growth opportunity variables, including the expected one-year and two-year earnings growth
rates, and expected long-term earnings growth rates. Despite the much smaller sample size, the
main conclusion drawn earlier remains robust. That is, after controlling for growth opportunities,
the market-to-book ratio continues to play a significant role in corporate financing decisions.
7
Conclusion
The market-to-book ratio and profitability are two important yet controversial capital structure
determinants. The importance of these two variables stems from their persistent power in predicting
corporate financing decisions. In fact, they have been a major source of inspiration that the costly
external financing theory relies upon to understand the capital structure decisions. Unfortunately,
it is hard to interpret the economic meaning of these two variables because predictions about them
are shared by the two main competing capital structure theories, namely the tradeoff theory and
the costly external financing theory, while the latter includes the pecking order theory and the
market timing hypothesis. Hence, uncovering the proper explanation behind these variables is not
only important for understanding them per se, but also critical for the assessment of the validity
of the two main schools of thought in the extant literature.
This paper contributes to the debate on the roles of these two variables in the following ways.
Departing from current literature, we conduct extensive tests on the scenarios where the two theories
either do not share the same predictions regarding these variables, or have opposite predictions.
In all cases, we find strong evidence in support of the costly external financing theory but not
compatible with the tradeoff theory. Particularly, firms with higher market-to-book ratios are
more likely to issue equity, not because they intend to downwardly adjust their target leverage
ratios, but more likely because they face lower external equity financing costs. In addition, firms
with higher profitability are more likely to issue debt, not necessarily because they are under-levered
and endeavor to move toward the target ratios, but more likely because they face lower external
debt financing costs. Extensive robustness checks confirm these findings.
22
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[28] Myers, S.C., 1984, The capital structure puzzle, Journal of Finance 39, 575-592.
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25
Appendix A: Variable Definitions
• Altman’s Z-score: 3.3 × Item 170/ Item 6 + Item 12/Item 6 + 1.4 × Item 36/Item 6 + 1.2 ×
(Item 4 - Item 5)/ Item 6)+ 0.6 × (Item 199 × Item 54)/(Item 34 + Item 9). The industry
adjusted Z-score is Z-score adjusted by the Fama and French (1997) 12 industry median for
each year.
• Advertising expenses: the ratio of Item 45 to Item 6.
• Cash holding: the ratio of Item 1 to Item 6.
• Commercial paper spread: the difference in yields between 3-month commercial papers and
T-bills.
• Deviation from the target: the difference between the target ratio and the lagged leverage
ratio.
• Financial deficit: the ratio of (Item 113 - Item 109 + Item 128 - Item 107 + Item 129 + Item
127 + Item 236 - Item 123 - Item 124 - Item 125 - Item 126 - Item 106 - Item 123) to Item 6.
• Gsales = log(Salest ) − log(Salest−1 )
• Industry-adjusted capital expenditure: defined as CAP X =
Item128
Item6
Capex−M Capex
, where
M Capex
Capex =
and M Capex is the median industry Capex.
• Industry median leverage ratio: the median leverage of firms in the same 12 Fama and French
industries in the same year.
• Interest coverage ratio: the ratio of Item 15 to Item 13.
• Inventory: the ratio of Item 3 to Item 6.
• LDA (Long-term debt / assets): the ratio of Item 9 to Item 6.
• LDM (Long-term debt / market value of assets): the ratio of Item 9 to MVA.
• Market-to-book ratio: ratio of MVA to Item 6.
• MVA (Market value of total asset): (Item 199 × Item 54) + Item 34 + Item 9 + Item 10 Item 35.
• NOLC (net operating losses carry forwards): the ratio of Item 52 to Item 6.
26
• Profitability (operating income before depreciation): ratio of Item 13 to Item 6.
• Profitbx (income before extraordinary items): the ratio of Item 18 to Item 6.
• Sales: the natural log of total sales in 1983 million dollar.
• Tangibility: the ratio of Item 8 to Item 6.
• T-bill: the 3-month Treasury bill rate.
• TDA (Total debt / assets): the ratio of (Item 34 + Item 9) to Item 6.
• TDM (Total debt / market value of assets): the ratio of (Item 34 + Item 9) to MVA (market
value of total assets).
• Two-year stock return: the split- and dividend-adjusted percentage return from the beginning
of the pre-issue year until close of the issue year.
27
Appendix B: Target Ratio Estimation
This appendix briefly discusses the target ratio estimation. Following Hovakimian, Opler, and
Titman (2001), the target ratio is the fitted value of the following regression:
T LEVit = Xit−1 × β + εit ,
(5)
where T LEVit is the target leverage ratio, β is the vector of coefficients, and Xit−1 is the vector
of determinants of the target leverage ratio. Frank and Goyal (2003 B) examine 39 factors that
might affect the target leverage ratio, and find that 7 of them have the most reliable explanatory
power. We use the same 7 factors in addition to profitability and the commercial paper spread as
the independent variables in the first stage regression. The commercial paper spread is defined as
the yield of 3-month commercial papers over a 3-month T-bill rate.24
The regression results are reported in Table A-1. The explanatory variables have the expected
signs, and are consistent across all four leverage ratio measures. In particular, industrial median
leverage ratio is meant to capture the strong industrial effect (MacKay and Phillips (2002)). As
expected, the coefficient is positive and significant. In addition, firms with lower bankruptcy
probability (high unlevered Z score) have lower leverage ratios. The unlevered Z-score (unlike the
Z-score in the main text), i.e., Z-score without the leverage ratio component, is used to avoid the
possible endogeneity problem when estimating the target ratios.
The variable size controls the size effect. Larger firms tend to have higher target leverage ratios.
The dividend paying dummy is equal to one if the firm pays dividend and zero otherwise. Firms
paying dividend (i.e., less financially constrained) have better access to the credit market and thus
might borrow more debt and have a higher leverage ratio. Alternatively, dividend paying firms may
have lower leverage because dividend can act as a check on management, causing less demand for
debt as a monitoring instrument. Controlling for size, we find firms paying dividend tend to have
lower leverage ratio.
Firms with higher intangible assets are more likely to borrow debt because intangible assets
can be used as collateral, and thus boost firms’ abilities to borrow debt (Frank and Goyal (2003)).
In addition, firms with higher market-to-book ratios tend to have lower target leverage ratios. The
usual argument is that these firms have higher growth opportunities; they thus keep lower leverage
ratios to retain investment flexibility. Furthermore, firms with higher proportional collateral values
tend to have higher target ratios, and those with higher profitability have lower leverage ratios. We
24
The inclusion of the commercial paper spread aims to capture the aggregate credit condition, in the spirit of
Korajczyk and Levy (2002).
28
use the commercial paper spread to proxy for the macroeconomic credit conditions. This variable
is positive and significant, consistent with the counter-cyclical leverage ratio finding in Korajczyk
and Levy (2002).
Finally, the estimated coefficients are used to calculate the predicted target ratio for each firmyear.
29
Table 1: Hypotheses of the Two Theories
The table summarizes the predictions by the tradeoff theory and the costly external
financing theory regarding the roles of the market-to-book ratio and profitability in
corporate financing decisions. BR denotes the bankruptcy risk.
Hypothesis
Firm Type
Low BR
Under-Levered
Medium BR
Around-the-Target
High BR
Over-Levered
Panel A: Higher market-to-book ratio firms issue more equity
The tradeoff theory
weak
Strong
weak
The costly external financing theory
Strong
Strong
Strong
Panel B: Higher market-to-book ratio firms issue more debt on a net basis
The tradeoff theory
No
No
No
The costly external financing theory
Yes
Yes
Yes
Panel C: Higher profitability firms issue more debt
The tradeoff theory
Strong
weak
weak
The costly external financing theory
Strong
Strong
Strong
30
Table 2: Firm Characteristics
Firms are separated into quintile groups according to Altman’s Z-score. See Appendix
A for variable definitions. Median firm characteristics are reported. In Panel C, we
provide four leverage ratio measures: TDM is total debt / market value of assets, LDM
is long-term debt / market value of assets, TDA is total debt / assets, and LDA is longterm debt / assets. We also provide two target leverage ratio measures: industry median
leverage ratio and the fitted leverage ratio. The former is the industry median (Fama
and French (1997)) in the same year, and the latter is estimated using the fixed-effect
model in Appendix A and Table A-1. All numbers presented are statistically significant
at the 5 percent level.
31
Table 2 – Continued
Group1
Group2
Group3
Group4
Group5
Panel A: General firm characteristics
Z-score
Industry-adjusted Z-score
Sales
Growth in sales (%)
Profitbx (%)
Profitability (%)
NOLC (%)
Two-year stock returns (%)
Advertising expenses (%)
Tangibility (%)
Market-to-book ratio (%)
1.31
-1.48
4.86
0.77
2.14
10.03
3.71
7.81
1.42
62.26
0.78
2.72
-0.99
5.10
0.68
3.23
11.73
0.00
11.90
1.98
34.56
0.72
3.93
-0.05
5.20
0.78
4.84
13.80
0.00
19.41
2.68
29.74
0.76
6.05
1.86
5.17
1.07
6.42
15.76
0.00
22.37
3.15
28.43
0.97
17.58
13.00
4.25
1.84
7.16
15.20
0.00
19.61
2.47
22.22
1.53
Panel B: Financial constraint characteristics
Interest coverage(%)
Cash holding(%)
Industry-adjusted capital expenditure(%)
Inventory (%)
Financial deficit (%)
1.56
2.44
-5.62
3.43
3.31
2.42
3.35
0
19.18
0.78
4.08
4.19
3.69
24.47
0.43
7.15
6.32
16.38
22.99
0.02
16.53
15.08
17.93
15.48
0.04
Panel C: Leverage ratios
Panel C1: Raw leverage
TDM
LDM
TDA
LDA
0.57
0.48
0.44
0.36
0.47
0.36
0.34
0.27
0.33
0.25
0.26
0.20
0.17
0.12
0.18
0.13
0.03
0.02
0.05
0.02
Panel C2: Deviation from the industry median leverage
TDM
-0.17
-0.18
LDM
-0.13
-0.16
TDA
-0.12
-0.09
LDA
-0.10
-0.09
-0.05
-0.06
-0.02
-0.04
0.07
0.03
0.05
0.01
0.13
0.07
0.12
0.07
Panel C3: Deviation from the fitted leverage (Appendix A)
TDM
-0.13
-0.09
LDM
-0.11
-0.06
TDA
-0.09
-0.05
LDA
-0.08
-0.03
0.02
0.03
0.01
0.01
0.15
0.12
0.08
0.07
0.20
0.15
0.16
0.13
32
Table 3: Distribution of Financing Types for Different Z-Score Groups
Firm years are separated into quintiles by Altman’s Z-score, and within each Z-score
panel, are separated into quintiles by the market-to-book ratio. See Appendix A for
variable definitions. We report the distribution of five types of financing decisions: dual
issue, pure debt issue, pure equity issue, doing nothing, and equity issue/debt reduction.
In the last row of each panel, the total number of observations is reported. In the other
rows, the percentage of each financing type out of the total number is reported. For
example, in Panel A, 1.56% of the 1,987 firm-years in the lowest market-to-book ratio
quintile have dual issues, and 4.97% of the 2,957 firm-years in the third market-to-book
ratio quintile have dual issues. The last two columns report the proportion test statistics
on the percentage differences between market-to-book Group 1 versus Group 3 and those
between Group 3 versus Group 5. For example, the test statistic of -6.31 for dual issues
in Panel A suggests that for firms belonging to the first Z-score quintile, those from
market-to-book Group 3 are significantly more likely to conduct dual issues than those
from market-to-book Group 1. ** denotes statistical significance at the 5 percent level,
and * denotes statistical significance at the 10 percent level.
33
Table 3 - Continued
Financing
Type
Market-to-Book Ratio
Group1
Group2
Group3
Group4
Group1 vs.
Group3 vs.
Group5
Group3
Group5
19.29
[-6.31]**
[-13.18]**
Panel A Firms in the first Z-score quintile (in percentage)
Dual issue
1.56
3.07
4.97
11.02
Pure debt issue
17.56
21.76
27.19
31.13
18.65
[-7.85]**
[4.89]**
Pure equity issue
3.02
4.17
6.59
11.39
21.19
[-5.57]**
[-12.32]**
Doing nothing
75.94
68.33
55.63
35.55
19.04
[14.57]**
[18.27]**
Equity issue/
1.91
2.67
5.61
10.90
21.83
[-6.42]**
[-14.11]**
1,987
3,451
2,957
1,606
788
debt reduction
Total num. of obs.
Panel B: Firms in the second Z-score quintile (in percentage)
Dual issue
0.54
1.43
1.87
5.94
12.68
[-4.85]**
[-11.68]**
Pure debt issue
18.47
21.58
27.09
32.70
29.65
[-7.88]**
[-1.16]
Pure equity issue
1.13
2.00
3.67
7.23
14.11
[-6.53]**
[-9.38]**
Doing nothing
79.30
73.26
64.58
47.27
29.24
[12.57]**
[14.53]**
Equity issue/
0.56
1.72
2.79
6.86
14.31
[-6.90]**
[-11.05]**
3,363
2,794
2,510
1,633
489
[-4.19]**
[-11.19]**
debt reduction
Total num. of obs.
Panel C: Firms in the third Z-score quintile (in percentage)
Dual issue
0.48
0.71
1.64
3.86
10.35
Pure debt issue
19.02
22.29
25.26
30.88
30.82
[-5.43]**
[-3.18]**
Pure equity issue
1.03
2.30
3.37
6.49
11.59
[-5.90]**
[-9.02]**
Doing nothing
79.02
73.62
68.39
53.68
37.01
[8.74]**
[16.22]**
Equity issue/
0.45
1.09
1.34
5.09
10.24
[-3.50]**
[-11.79]**
2,908
2,396
2,316
2,280
889
debt reduction
Total num. of obs.
Panel D: Firms in the fourth Z-score quintile (in percentage)
Dual issue
0.34
0.87
1.19
2.91
6.85
[-2.92]**
[-9.31]**
Pure debt issue
16.55
19.56
22.06
26.60
28.38
[-4.26]**
[-4.85]**
[-10.51]**
Pure equity issue
1.31
1.55
3.17
4.60
11.61
[-3.80]**
Doing nothing
81.63
77.69
72.50
63.91
45.68
[6.62]**
[18.15]**
Equity issue/
0.17
0.34
1.09
1.98
7.49
[-3.47]**
[-10.18]**
1,758
1,488
2,022
3,023
2,498
[-5.40]**
debt reduction
Total num. of obs.
Panel E: Firms in the fifth Z-score quintile (in percentage)
Dual issue
0.52
0.76
1.42
1.38
5.40
[-1.87]*
Pure debt issue
10.09
11.52
14..63
17.22
16.97
[-2.85]**
[-1.82]*
Pure equity issue
1.29
1.52
3.05
5.79
18.26
[-2.45]**
[-12.03]**
Doing nothing
87.97
85.91
80.69
75.34
56.63
[4.11]**
[14.30]**
Equity issue/
0.13
0.30
0.20
0.27
2.74
[-0.37]
[-4.84]**
773
660
984
2,247
6,124
debt reduction
Total num. of obs.
34
Table 4: Distribution of Financing Types for Different Growth Groups
Using Alternative Growth Measures
Firm years are separated into quintiles by proxies for growth opportunities (i.e., the sales
growth rate in Panel A and capital expenditure in Panel B), and within each growth
variable quintile, are separated into quintiles by the market-to-book ratio. The idea is
to study whether the market-to-book ratio can still affect corporate financing decisions
after controlling for the growth opportunities. See Appendix A for variable definitions.
We report the distribution of five types of financing decisions: dual issue, pure debt issue,
pure equity issue, doing nothing, and equity issue/debt reduction. In the last row of each
sub-panel, the total number of observations is reported. In other rows, the percentage
of each financing type out of the total number is reported. For example, in Sub-panel
A1, there are 3,116 firm-years in the first market-to-book ratio quintile. Among them,
0.90% have dual issue and 1.54% have pure equity issue. The last two columns report the
proportion test statistics on the percentage differences between market-to-book Group
1 versus Group 3 and those between Group 3 versus Group 5. ** denotes statistical
significance at the 5 percent level, and * denotes statistical significance at the 10 percent
level.
35
Table 4 - Continued
Panel A: Growth in sales as the measure of growth potential
Financing
Type
Market-to-Book Ratio
Group1
Group2
Group3
Group4
Group5
Group1 vs.
Group3 vs.
Group3
Group5
Panel A1: Firms in the first sales growth quintile (in percentage)
Dual issue
0.90
1.18
1.75
4.20
10.01
[-2.62 ]**
[-9.96]**
Pure debt issue
14.67
17.40
20.10
19.42
15.42
[-4.91]**
[3.16]**
Pure equity issue
1.54
3.13
4.40
9.09
22.72
[-6.07]**
[-15.02]**
Doing nothing
82.19
75.83
69.11
60.26
39.68
[10.51]**
[15.57]**
Equity issue/
0.71
2.45
4.63
7.02
12.17
[-9.14]**
[-7.46]**
3,116
2,201
1,771
1,452
1,109
[-3.45]**
[-0.94]
debt reduction
Total num. of obs.
Panel A2: Firms in the second sales growth quintile (in percentage)
Dual issue
0.45
0.91
1.37
1.52
1.87
Pure debt issue
15.30
16.68
19.00
20.87
21.44
[-3.38]**
[-1.40]
Pure equity issue
0.86
2.19
3.13
3.96
3.88
[-5.77]**
[-0.97]
Doing nothing
82.83
79.51
75.23
71.20
70.65
[6.47]**
[2.39]**
Equity issue/
0.56
0.72
1.28
2.44
2.16
[-2.65]**
[-1.66]*
2,679
2,650
2,111
1,514
695
debt reduction
Total num. of obs.
Panel A3: Firms in the third sales growth quintile (in percentage)
Dual issue
0.31
1.58
2.02
1.77
1.28
[-5.01]**
[1.57]
Pure debt issue
18.47
19.74
21.52
23.24
19.40
[-2.46]**
[1.45]
Pure equity issue
1.55
2.44
3.60
3.34
4.09
[-4.13]**
[-0.71]
Doing nothing
79.21
75.09
71.63
69.46
73.70
[5.67]**
[-1.29]
Equity issue/
0.46
1.15
1.23
2.19
1.53
[-2.66]**
[-0.73]
1,938
2,340
2,277
1,919
1,175
[-4.66]**
[-2.47]**
debt reduction
Total num. of obs.
Panel A4: Firms in the fourth sales growth quintile (in percentage)
Dual issue
0.51
2.46
2.50
3.70
3.88
Pure debt issue
22.16
24.67
28.27
30.43
24.09
[-4.19]**
[ 2.98]**
Pure equity issue
1.22
2.97
4.25
4.97
8.14
[-5.35]**
[-5.11]**
Doing nothing
75.53
68.77
62.72
57.94
60.19
[ 8.24]**
[ 1.63]
Equity issue/
0.58
1.13
2.27
2.97
3.71
[-4.09]**
[-2.69]**
1,557
1,950
2,119
2,192
1,831
[-4.89]**
debt reduction
Total num. of obs.
Panel A5: Firms in the fifth sales growth quintile (in percentage)
Dual issue
1.18
2.92
4.83
7.14
8.60
[-4.63]**
Pure debt issue
22.16
28.96
32.51
33.48
24.14
[-5.41]**
[6.41]*
Pure equity issue
2.37
3.11
5.18
8.97
18.08
[-3.31]**
[-12.65]**
Doing nothing
73.58
61.89
53.36
44.17
42.34
[ 9.80]**
[ 7.51]**
Equity issue/
0.71
3.11
4.12
6.24
6.84
[-4.76]**
[-3.90]**
844
1,060
1,698
2,452
3,595
debt reduction
Total num. of obs.
36
Table 4 - Continued
Panel B: Industry-adjusted capital expenditure as the measure of growth potential
Financing
Type
Market-to-Book Ratio
Group1
Group2
Group3
Group4
Group1 vs.
Group3 vs.
Group3
Group5
Group5
Panel B1: Firms in the first capital expenditure quintile (in percentage)
Dual issue
0.89
1.31
2.74
5.35
9.21
[-5.06]**
[-8.34]**
Pure debt issue
13.71
18.52
18.61
22.02
15.44
[-4.61]**
[2.55]**
Pure equity issue
1.51
2.06
5.27
7.95
21.90
[-7.60]**
[-14.83]**
Doing nothing
82.97
75.72
68.74
57.89
44.58
[11.66]**
[14.79]**
Equity issue/
0.92
2.39
4.64
6.79
8.87
[-8.41]**
[-5.14]**
3,048
2,138
1,897
1,812
1,781
[-4.05]**
[-7.78]**
debt reduction
Total num. of obs.
Panel B2: Firms in the second capital expenditure quintile (in percentage)
Dual issue
0.70
1.04
2.05
3.47
7.29
Pure debt issue
14.01
17.31
20.54
23.25
17.42
[-5.92]**
[2.40]**
Pure equity issue
1.28
2.19
3.72
5.71
16.18
[-5.44]**
[-13.07]**
Doing nothing
83.31
78.22
70.83
62.77
53.68
[10.20]**
[10.76]**
Equity issue/
0.70
1.24
2.86
4.80
5.44
[-5.74]**
[-3.98]**
2,577
2,507
2,098
1,875
1,619
debt reduction
Total num. of obs.
Panel B3: Firms in the third capital expenditure quintile (in percentage)
Dual issue
0.37
1.59
2.07
2.91
5.51
[-5.12]**
[-5.87]**
Pure debt issue
17.61
18.39
23.13
23.77
19.98
[-4.58]**
[2.42]**
[-11.88]**
Pure equity issue
1.71
2.67
3.80
5.40
14.13
[-4.23]**
Doing nothing
79.84
76.11
69.31
64.45
55.11
[8.06]**
[9.32]**
Equity issue/
0.46
1.23
1.68
3.48
5.28
[-3.92]**
[-6.43]**
2,158
2,512
2,317
1,927
1.762
[-5.35]**
[-4.96]**
debt reduction
Total num. of obs.
Panel B4: Firms in the fourth capital expenditure quintile (in percentage)
Dual issue
0.56
2.02
2.82
3.86
5.83
Pure debt issue
20.97
23.07
25.88
28.26
22.03
[-3.65]**
[3.01]**
Pure equity issue
1.62
3.25
4.27
5.87
14.16
[-4.84]**
[-11.47]**
Doing nothing
76.52
70.03
65.05
58.62
52.53
[7.93]**
[8.51]**
Equity issue/
0.33
1.63
1.98
3.40
5.46
[-4.68]**
[-6.17]**
1,793
2,029
2,272
2,385
2,197
[-8.52]**
debt reduction
Total num. of obs.
Panel B5: Firms in the fifth capital expenditure quintile (in percentage)
Dual issue
0.79
2.84
2.92
6.03
8.81
[-3.96]**
Pure debt issue
29.67
31.55
34.45
35.19
27.50
[-2.77]**
[ 5.41]**
Pure equity issue
1.23
3.30
4.11
8.03
15.52
[-4.51]**
[-12.98]**
Doing nothing
67.34
60.66
56.03
47.06
41.83
[6.27]**
[10.16]**
Equity issue/
0.97
1.65
2.49
3.69
6.34
[-2.98]**
[-6.41]**
1,136
1,515
2,090
2,654
3,280
debt reduction
Total num. of obs.
37
Table 5: Distribution of Financing Types for Different Profitability Groups
Firm years are separated into quintiles by Altman’s Z-score, and within each Z-score
panel, are separated into quintiles by profitability. See Appendix A for variable definitions. We report the distribution of five types of financing decisions: dual issue, pure
debt issue, pure equity issue, doing nothing, and equity issue/debt reduction. In the
last row of each Panel, the total number of observations is reported. In other rows, the
percentage of each financing type out of the total number is reported. For example,
in Panel A, there are 3,636 firm-years in the first profitability quintile. Among them,
8.47% have dual issue and 11.96% have pure equity issue. The last two columns report
the proportion test statistics on the percentage differences between profit Group 1 versus
Group 3 and those between Group 3 versus Group 5. ** denotes statistical significance
at the 5 percent level, and * denotes statistical significance at the 10 percent level.
38
Table 5 - Continued
Financing
Type
Profitability
Group1
Group2
Group3
Group4
Group1 vs.
Group3 vs.
Group5
Group3
Group5
[7.85]**
[-2.61]**
Panel A: Firms in the first Z-score quintile (in percentage)
Dual issue
8.47
4.62
3.52
4.34
6.96
Pure debt issue
21.40
24.70
23.57
24.62
40.43
[-2.03]**
[-5.67]**
Pure equity issue
11.96
5.00
3.91
3.58
3.91
[11.15]**
[-0.00]
Doing nothing
46.12
62.51
67.14
63.99
41.30
[-16.42]**
[7.88]**
Equity issue/
12.05
3.16
1.86
3.47
7.39
[14.75]**
[-5.35]**
3,636
3,417
2,584
922
230
debt reduction
Total num. of obs.
Panel B: Firms in the second Z-score quintile (in percentage)
Dual issue
3.57
1.70
2.35
2.45
3.12
[ 2.53]**
[-1.16]
Pure debt issue
19.19
22.06
24.62
27.57
32.05
[-4.46]**
[-3.97]**
Pure equity issue
6.10
2.79
2.55
3.03
4.30
[6.26]**
[-2.47]**
Doing nothing
65.44
71.24
68.11
64.68
57.27
[-1.94]*
[5.37]**
Equity issue/
5.69
2.21
2.38
2.26
3.26
[ 6.03]**
[-1.32]
1,933
3,119
2,985
2,078
674
debt reduction
Total num. of obs.
Panel C: Firms in the third Z-score quintile (in percentage)
Dual issue
5.21
1.60
1.89
2.04
2.13
[5.69]**
[-0.59]**
Pure debt issue
20.19
22.95
24.30
25.36
28.18
[-2.83]**
[-2.92]**
Pure equity issue
8.81
4.03
2.73
2.74
3.68
[8.34]**
[-1.80]*
Doing nothing
61.54
68.84
68.85
67.85
63.18
[-4.50]**
[3.96]**
Equity issue/
4.25
2.58
2.23
2.01
2.83
[3.49]**
[-1.26]
1,248
1,935
2,597
3,135
1,874
debt reduction
Total num. of obs.
Panel D: Firms in the fourth Z-score quintile (in percentage)
Dual issue
8.26
2.50
1.77
2.25
1.89
[8.31]**
[-0.32]
Pure debt issue
19.88
23.16
24.41
23.44
24.67
[-2.92]**
[-0.21]
Pure equity issue
14.11
3.99
3.77
3.95
3.54
[10.05]**
[0.42]
Doing nothing
51.75
67.84
68.05
68.76
67.50
[-8.96]**
[0.40]
Equity issue/
6.00
2.50
2.01
1.60
2.40
[ 5.64]**
[-0.90]
1,283
1,278
1,643
2,884
3,701
[7.80]**
[0.69]**
[0.94]
debt reduction
Total num. of obs.
Panel E: Firms in the fifth Z-score quintile (in percentage)
Dual issue
9.11
2.88
1.63
2.03
1.35
Pure debt issue
11.57
17.02
17.96
19.21
16.71
[-5.05]**
Pure equity issue
27.48
6.35
7.45
7.51
6.66
[12.93]**
[0.89]
Doing nothing
48.38
72.98
71.53
70.11
74.26
[-12.46]**
[-1.75]*
Equity issue/
3.46
0.77
1.43
1.13
1.02
[3.23]**
[1.11]
2,689
1,040
980
1,770
4,309
debt reduction
Total num. of obs.
39
Table 6: Multinomial Logistic Regression
Comparing Financing Decisions
In the multinomial logistic regression, we study five types of financing decisions: dual
issue, pure debt issue, pure equity issue, doing nothing, and equity issue/debt reduction.
Type 4 (doing nothing) is the base category. Lagged independent variables are used.
See Appendix A for variable definitions. Market-to-book i denotes the market-to-book
ratio of firms that belong to the ith quintile of Z-scores. Similarly, Profit i denotes the
profitability of firms that belong to the ith quintile of Z-scores. Coefficient estimates are
reported in the first row and standard errors are reported in parentheses in the second
row. ** denotes significance at the 5 percent level and * denotes significance at the 10
percent level.
40
Table 6 – Continued
Dual Issue
Intercept
Deviation from target
Two-year stock returns
Size
Financial deficit
T-bill
Market-to-book 1
Market-to-book 2
Market-to-book 3
Market-to-book 4
Market-to-book 5
Profit 1
Profit 2
Profit 3
Profit 4
Profit 5
Pseudo R square
Dep. Var=1
Dep. Var=0
-3.60
(0.10)**
0.96
(0.16)**
0.20
(0.01)**
-0.22
(0.01)**
1.20
(0.09)**
0.03
(1.02%)**
1.75
(0.05)**
1.33
(0.06)**
1.20
(0.05)**
0.88
(0.03)**
0.33
(0.01)**
0.74
(0.26)**
-0.11
(0.47)
-1.47
(0.44)**
-1.62
(0.31)**
-1.32
(0.21)**
Pure Debt
Issue
-1.32
(0.05)**
0.14
(0.07)**
-0.00
(0.01)
-0.09
(0.01)**
0.74
(0.07)**
-0.02
(0.44%)**
1.08
(0.04)**
0.84
(0.05)**
0.76
(0.04)**
0.54
(0.03)**
0.11
(0.01)**
0.96
(0.21)**
2.11
(0.30)**
1.85
(0.26)**
1.28
(0.21)**
0.96
(0.16)**
Pure Equity
Issue
-2.54
(0.08)**
1.62
(0.13)**
0.23
(0.01)**
-0.26
(0.01)**
1.02
(0.08)**
0.02
(0.80%)*
1.49
(0.05)**
1.03
(0.06)**
0.97
(0.05)**
0.73
(0.03)**
0.36
(0.01)**
0.13
(0.22)
-1.66
(0.42)**
-1.95
(0.38)**
-2.07
(0.27)**
-1.07
(0.18)**
Debt Reduction /
Equity Issue
-3.29
(0.11)**
-1.09
(0.15)**
0.19
(0.01)**
-0.24
(0.01)**
1.07
(0.09)**
-0.03
(1.09%)**
1.72
(0.05)**
1.41
(0.06)**
1.33
(0.05)**
0.96
(0.04)**
0.29
(0.02)**
-0.30
(0.24)
-0.28
(0.47)
-0.10
(0.45)**
-0.61
(0.35)*
-0.79
(0.27)**
0.10
1,813
35,014
12,049
35,014
3,373
35,014
1,695
35,014
41
Table 7: Logistic Regressions
Debt vs. Equity Issues
In the logistic regressions, we study pure debt (y =1) versus pure equity (y =0) financing
decisions. See Appendix A for variable definitions. We provide four leverage ratio
measures: TDM is total debt / market value of assets, LDM is long-term debt / market
value of assets, TDA is total debt / assets, and LDA is long-term debt / assets. Marketto-book i denotes the market-to-book ratio of firms that belong to the ith quintile of Zscores. Similarly, Profit i denotes the profitability of firms that belong to the ith quintile
of Z-scores. ** denotes significance at the 5 percent level and * denotes significance at
the 10 percent level.
42
Table 7 – Continued
TDM
Coeff. (S.E.)
Est.
LDM
Coeff. (S.E.)
Est.
TDA
Coeff. (S.E.)
Est.
LDA
Coeff. (S.E.)
Est.
Intercept
1.18
(0.09)**
1.25
(0.09)**
1.31
(0.10)**
1.24
(0.10)**
Deviation from target
-1.13
(0.15)**
-0.49
(0.16)**
-0.75
(0.19)**
0.13
(0.18)
Two-year
-0.22
(0.02)**
-0.21
(0.01)**
-0.22
(0.02)**
-0.21
(0.01)**
Size
0.17
(0.01)**
0.15
(0.01)**
0.15
(0.01)**
0.15
(0.01)**
Financial deficit
-0.22
(0.10)**
-0.30
(0.10)**
-0.28
(0.10)**
-0.31
(0.10)**
T-bill
-0.04
(0.01)**
-0.04
(0.01)**
-0.04
(0.01)**
-0.03
(0.01)**
Market-to-book 1
-0.28
(0.05)**
-0.24
(0.05)**
-0.36
(0.06)**
-0.18
(0.06)**
Market-to-book 2
-0.14
(0.06)*
-0.15
(0.06)*
-0.24
(0.06)**
-0.13
(0.06)
Market-to-book 3
-0.21
(0.05)**
-0.24
(0.05)**
-0.31
(0.06)**
-0.24
(0.05)**
Market-to-book 4
-0.22
(0.04)**
-0.26
(0.04)**
-0.30
(0.04)**
-0.27
(0.04)**
Market-to-book 5
-0.30
(0.02)**
-0.33
(0.02)**
-0.33
(0.02)**
-0.34
(0.02)**
Profit 1
0.88
(0.26)**
1.05
(0.27)**
1.01
(0.26)**
1.36
(0.27)**
Profit 2
3.53
(0.47)**
3.84
(0.47)**
3.77
(0.47)**
4.15
(0.47)**
Profit 3
4.11
(0.45)**
4.17
(0.45)**
4.09
(0.46)**
4.30
(0.46)**
Profit 4
3.54
(0.35)**
3.34
(0.35)**
3.25
(0.35)**
3.30
(0.35)**
Profit 5
2.11
(0.24)**
1.94
(0.24)**
1.91
(0.24)**
1.89
(0.23)**
Pseudo R square
0.19
0.18
Dep.Var =1
3,373
3,373
3,373
3,373
Dep.Var =0
12,049
12,049
12,049
12,049
stock returns
43
0.19
0.18
Table 8: Multinomial Logistic Regression Comparing Financing Decisions
with Decomposition of the Market-to-Book Ratio
The multinomial logistic regression is the same as that in Table 6 except that we decompose the firm-specific market-to-book ratio into three components: the component of
market-to-book ratio that is related to the growth opportunities (denoted as GROWTH),
the component that can be explained but not directly related to growth opportunities
(denoted as NGROWTH), and the residual component that can not be explained (denoted as FIRM). In addition, we add a change-of-growth component that is equal to
the change of the growth component (denoted as CGROWTH). See text for variable
constructions. For each component, we further construct five variables that interact
with Z-score quintiles, exactly matching what we do with the market-to-book ratio in
Table 6. Thus, the number i (i = 1, ..., 5) at the end of each component means that
the variable applies to firms in the ith Z-score quintile. For brevity, we only report the
decomposed market-to-book ratio coefficients. Coefficient estimates are reported in the
first row and standard deviations are reported in parentheses in the second row. **
denotes significance at the 5 percent level and * denotes significance at the 10 percent
level.
44
Table 8 – Continued
FIRM 1
FIRM 2
FIRM 3
FIRM 4
FIRM 5
NGROWTH 1
NGROWTH 2
NGROWTH 3
NGROWTH 4
NGROWTH 5
GROWTH 1
GROWTH 2
GROWTH 3
GROWTH 4
GROWTH 5
CGROWTH 1
CGROWTH 2
CGROWTH 3
CGROWTH 4
CGROWTH 5
Pseudo R square
Dep. Var=1
Dep. Var=0
Dual Issue
1.73
(0.15)**
2.48
(0.18)**
2.30
(0.16)**
1.68
(0.12)**
0.80
(0.08)**
2.76
(0.21)**
3.65
(0.22)**
2.87
(0.22)**
1.98
(0.20)**
0.37
(0.16)**
1.87
(0.77)**
6.76
(1.13)**
5.90
(1.10)**
4.68
(0.82)*
3.16
(0.57)**
-0.57
(0.56)
3.76
(0.95)**
1.67
(1.00)*
0.38
(0.67)
0.72
(0.47)**
Pure Debt
0.65
(0.08)**
0.73
(0.07)**
0.58
(0.07)**
0.59
(0.06)**
0.20
(0.05)**
1.27
(0.11)**
1.61
(0.09)**
1.26
(0.09)**
1.04
(0.08)**
0.27
(0.07)**
2.04
(0.50)**
4.52
(0.65)**
4.61
(0.66)**
3.41
(0.60)**
1.72
(0.45)**
0.76
(0.35)**
2.67
(0.54)**
2.17
(0.56)**
1.29
(0.48)**
0.37
(0.39)
Pure Equity
1.24
(0.13)**
1.95
(0.15)**
1.84
(0.14)**
1.57
(0.10)**
1.04
(0.06)**
1.88
(0.18)**
2.92
(0.20)**
2.19
(0.19)**
1.72
(0.16)**
1.24
(0.10)**
1.98
(0.66)**
5.04
(1.06)**
5.31
(1.00)**
3.62
(0.76)**
2.65
(0.46)**
0.09
(0.44)
3.18
(0.84)**
2.56
(0.85)*
-0.03
(0.61)
0.39
(0.38)
Debt Reduction/Equity Issue
2.00
(0.14)**
2.76
(0.17)**
2.62
(0.16)**
2.09
(0.12)**
0.68
(0.10)**
2.74
(0.20)**
3.58
(0.23)**
3.04
(0.22)**
2.44
(0.20)**
-0.05
(0.21)**
0.65
(0.67)
6.11
(1.09)**
5.54
(1.13)**
3.34
(0.91)**
2.62
(0.71)**
-0.85
(0.43)*
2.15
(0.96)**
1.43
(1.00)
-0.37
(0.71)
0.67
(0.56)
0.10
1,610
34,311
11,785
34,311
2,979
34,311
1,527
34,311
45
Table 9: Logistic Regressions With Decomposition of the Market-to-Book Ratio
Debt vs. Equity Issues
The logistic regressions are the same as that in Table 7 except that we decompose the
firm-specific market-to-book ratio into three components: the component of marketto-book ratio that is related to the growth opportunities (denoted as GROWTH), the
component that can be explained but not directly related to growth opportunities (denoted as NGROWTH), and the residual component that can not be explained (denoted
as FIRM). In addition, we add a change-of-growth component that is equal to the change
of the growth component (denoted as CGROWTH). See text for variable constructions.
For each component, we further construct five variables that interact with Z-score quintiles, exactly matching what we do with the market-to-book ratio in Table 7. Thus, the
number i (i = 1, ..., 5) at the end of each component means that the variable applies
to firms in the ith Z-score quintile. ** denotes significance at the 5 percent level and *
denotes significance at the 10 percent level.
46
Table 9 – Continued
TDM
Coeff. (S.E.)
Est.
LDM
Coeff. (S.E.)
Est.
TDA
Coeff. (S.E.)
Est.
LDA
Coeff. (S.E.)
Est.
FIRM 1
-0.50
(0.14)**
-0.63
(0.14)**
-0.65
(0.14)**
-0.58
(0.14)**
FIRM 2
-1.04
(0.17)**
-1.15
(0.16)**
-1.16
(0.16)**
-1.11
(0.16)**
FIRM 3
-1.06
(0.15)**
-1.13
(0.15)**
-1.15
(0.15)**
-1.10
(0.15)**
FIRM 4
-0.92
(0.12)**
-0.99
(0.12)**
-0.98
(0.12)**
-0.96
(0.12)**
FIRM 5
-0.91
(0.07)**
-0.95
(0.07)**
-0.90
(0.07)**
-0.94
(0.07)**
NGROWTH 1
-0.58
(0.20)**
-0.64
(0.20)**
-0.70
(0.20)**
-0.62
(0.20)**
NGROWTH 2
-1.19
(0.21)**
-1.26
(0.21)**
-1.29
(0.21)**
-1.25
(0.21)**
NGROWTH 3
-0.76
(0.20)**
-0.80
(0.20)**
-0.83
(0.20)**
-0.79
(0.20)**
NGROWTH 4
-0.79
(0.18)**
-0.84
(0.18)**
-0.82
(0.18)**
-0.82
(0.18)**
NGROWTH 5
-1.20
(0.13)**
-1.27
(0.13)**
-1.18
(0.13)**
-1.25
(0.13)**
GROWTH 1
-0.78
(0.73)
-0.73
(0.73)
-0.95
(0.74)
-0.76
(0.74)
GROWTH 2
-0.53
(1.14)
-0.62
(1.15)
-0.63
(1.15)
-0.58
(1.15)
GROWTH 3
-0.89
(1.04)
-1.01
(1.04)
-0.98
(1.04)
-0.96
(1.04)
GROWTH 4
-0.74
(0.76)
-0.88
(0.76)
-0.78
(0.76)
-0.83
(0.76)
GROWTH 5
-1.94
(0.62)**
-2.10
(0.61)**
-1.93
(0.62)**
-2.04
(0.61)**
CGROWTH 1
-0.17
(0.55)
0.09
(0.56)
-0.20
(0.56)
-0.12
(0.55)
CGROWTH 2
-0.62
(1.05)
-0.65
(1.06)
-0.63
(1.05)
-0.63
(1.05)
CGROWTH 3
-0.59
(0.87)
-0.62
(0.88)
-0.60
(0.87)
-0.61
(0.88)
CGROWTH 4
0.47
(0.59)
0.42
(0.58)
0.47
(0.59)
0.44
(0.59)
CGROWTH 5
-0.79
(0.56)
-0.27
(0.47)
-0.79
(0.56)
-0.85
(0.55)
Pseudo R square
0.17
0.17
0.17
0.17
Dep.Var =1
2,979
2,979
2,979
2,979
Dep.Var =0
11,785
11,785
11,785
11,785
47
Table A-1: Fixed-Effect Regression
Predicting the Target Leverage Ratios
A fixed-effect model is used to estimate the target leverage ratio. Four leverage
ratio measures are used: TDM (Total debt/market value of assets), LDM (Longterm debt/market value of assets), TDA (Total debt/assets), and LDA (Long
term debt/assets). The choice of independent variables, except for commercial
paper spread and profit, follows Frank and Goyal (2003 B). See Appendix A
for definitions. Z-values are reported in parentheses.
TDM
Intercept
Industry median
Z-score (un-levered)
Sales
Dividend
Intangible
Market-to-book
Collateral
Profitability
Commercial paper spread
R square
Total observations
LDM
TDA
LDA
-0.02
-0.02
0.04
0.02
(-1.96)
(-2.87)
(5.46)
(3.42)
0.40
0.41
0.39
0.36
(37.75)
(33.75)
(22.17)
(19.24)
-1.21%
-0.89%
-1.50%
-1.09%
(-16.24)
(-13.51)
(-27.08)
(-21.31)
0.04
0.03
0.02
0.02
(31.49)
(28.49)
(21.21)
(20.81)
-0.04
-0.03
-0.02
-0.02
(-13.70)
(-11.75)
(-9.81)
(-7.90)
0.27
0.24
0.25
0.22
(20.54)
(20.79)
(25.06)
(24.78)
-1.55%
-1.02%
-0.38%
-0.14%
(-27.34)
(-20.44)
(-8.96)
(-3.57)
0.18
0.14
0.14
0.11
(24.22)
(21.13)
(25.25)
(20.69)
-0.12
-0.08
-0.03
-0.01
(-15.05)
(-11.84)
(-5.85)
(-2.08)
0.52%
0.87%
0.19%
0.18%
(3.11)
(6.32)
(1.69)
(1.74)
0.25
0.28
0.17
0.20
53,944
53,944
53,944
53,944
48
Table A-2: Regression of Market-to-Book Ratios
We regress the market-to-book ratio on a list of variables, in an effort to decompose
the market-to-book ratio into components that are related to growth opportunities and
those that are not related. We first group all firms into 12 industries following Fama and
French (1997) and exclude the 11th industry that is related to financial firms (money).
We then run the following regression for each industry year:
LogMBit = (α0 + α1 × Profitit + α2 × Leverageit ) + (α3 × Gsalesit + α4 × CAPXit ) + (εit )
See text for variable definitions. For each variable, the time series average coefficients are
reported in the first column and their standard deviations are reported in the parentheses
in the second column.
49
50
1
2
3
4
5
6
7
8
9
10
12
Industry
Intercept
Coefficient (S.E.)
-0.10
(0.05)
-0.11
(0.05)
-0.21
(0.04)
-0.07
(0.05)
0.18
(0.04)
0.18
(0.05)
0.04
(0.06)
-0.64
(0.04)
-0.22
(0.04)
0.60
(0.05)
-0.23
(0.03)
Profitability
Coefficient (S.E.)
0.52
(0.88)
1.98
(1.59)
0.58
(1.04)
3.14
(2.03)
7.97
(3.65)
-1.30
(0.28)
5.96
(3.46)
83.29
(21.12)
2.10
(2.01)
-3.10
(1.30)
8.21
(3.88)
TDA
Coefficient
-0.04
-0.15
0.06
0.15
-0.74
-0.20
0.12
0.76
0.07
-0.77
0.03
(S.E.)
(0.06)
(0.09)
(0.05)
(0.07)
(0.11)
(0.05)
(0.07)
(0.07)
(0.05)
(0.11)
(0.05)
Gsales
Coefficient (S.E.)
0.82
(0.16)
1.11
(0.31)
0.71
(0.07)
0.07
(0.03)
1.44
(0.38)
0.68
(0.10)
0.86
(0.24)
0.41
(0.28)
0.81
(0.22)
1.05
(0.30)
0.44
(0.16)
Table A-2 – Continued
CAPX
Coefficient (S.E.)
0.10
(0.01)
0.05
(0.01)
0.08
(0.01)
0.18
(0.02)
0.13
(0.02)
0.09
(0.01)
0.11
(0.02)
0.15
(0.02)
0.11
(0.01)
0.08
(0.01)
0.08
(0.01)
0.09
0.14
0.07
0.15
0.20
0.10
0.17
0.29
0.12
0.16
0.10
R-square