Capital Structure Instability

• DOI: http://doi.org/10.1111/jacf.12203
• Published date: 01 December 2016
• Date: 01 December 2016

In This Issue: Capital Structure and Payout Policy

A Look Back at Modern Finance: Accomplishments and Limitations

An Interview with Eugene Fama

10 Eugene Fama, University of Chicago,

with Joel Stern, Stern Value Management

Proactive Leverage Increases and The Value of Financial Flexibility 17 David J. Denis, University of Pittsburgh, and

Stephen B. McKeon, University of Oregon

The Leveraging of Corporate America: A Long-Run Perspective on

Changes in Capital Structure

29 John R. Graham, Duke University, Mark T. Leary,

Washington University in St. Louis, and Michael R. Roberts,

University of Pennsylvania

Capital Structure Instability 38 Harry DeAngelo, University of Southern California, and

Richard Roll, Caltech and University of California at

Los Angeles

Which Creditors’ Rights Drive Financial Deepening

and Economic Development?

53 Charles W. Calomiris. Columbia University, Mauricio Larrain,

Ponticia Universidad Católica de Chile, and

José Liberti and Jason Sturgess, DePaul University

The Capital Structure of PE-Funded Companies (and How New Debt

Instruments and Investors Are Expanding Their Debt Capacity)

60 Joseph V. Rizzi, Macro Strategies LLC and DePaul University

Seniority Differentials in High Yield Bonds: Evolution, Valuation, and Ratings 68 Martin Fridson, Lehmann Livian Fridson Advisors LLC,

Yanzhe Yang and Jiajun Wang, FridsonVision LL

Do Corporate Managers Know When Their Shares Are Undervalued?

New Evidence Based on Actual (and Not Just Announced) Stock Buybacks

73 Amy Dittmar, University of Michigan, and

Laura Casares Field, University of Delaware

A Primer on the Financial Policies of Chinese Firms:

A Multi-country Comparison

86 Marc Zenner, Peter McInnes, Ram Chivukula, and

Phu Le, J.P. Morgan

Syndication of European Buyouts and its Effects on Target-Firm Performance 96 Nancy Huyghebaert, KU Leuven, and Randy Priem,

Financial Services and Markets Authority

Don’t Waste a Free Lunch: Managing the Advance Refunding Option 118 Andrew Kalotay, Andrew Kalotay Associates, Inc. and

Lori Raineri, Government Financial Strategies

The Economic Impact of Chapter 11 Bankruptcy versus Out-of-Court Restructuring 124 Donald Markwardt, Claude Lopez, and Ross DeVol,

Milken Institute

VOLUME 28 | NUMBER 4 | FALL 2016

APPLIED CORPORATE FINANCE

Journal of

38 Journal of Applied Corporate Finance • Volume 28 Number 4 Fall 2016

Capital Structure Instability

* This paper is a shorter, less technical, version of an article titled, “How Stable Are

Corporate Capital Structures?” which we published in the Journal of Finance, Vol. 70,

No. 1, February 2015. It is published with the permission of John Wiley & Co., the

publisher of the Journal of Finance.

1. Graham and Harvey (2001, p. 21). Full citations of all articles mentioned in the

text and footnotes are provided in the References section at the end of the article.

2. The view that leverage is stable over long horizons was rst advanced by Lemmon,

Roberts, and Zender (2008, LRZ). In their prominent review of empirical studies of

capital structure, Frank and Goyal (2008, p. 156) cite LRZ for rm-level stability evi-

dence and conclude that “a satisfactory theory must account for why rms keep leverage

stationary.” Rauh and Su (2011, p. 5) also cite LRZ’s evidence and state that “the ex-

tant research strongly argues that cross-sectional variation in corporate capital structure

is where researchers should focus.”

A

ccording to many corporate-f inance special-

ists and virtu ally all modern nance textbooks,

companies have optimal capital structures w ith

leverage targets t hat are determined by trading

o tax benets of debt against nancial dist ress and agency

costs. Although m anagerial su rveys conf irm that many

companies have leverage ta rgets, it is unclear whether such

targets often impose mea ningful limits in the variat ion over

time in capital struc ture. For example, a prominent survey of

some 400 U.S. corporate CFOs reported that 81% of respon-

dents said that their companies h ad a target leverage ratio or

a target leverage “zone,” but only 10% said that their compa-

nies had a strict target.¹ If a leverage target serves only as a

rough nancial pla nning guide, then the existence of a ta rget

is fully compatible with wide va riation over time in a compa-

ny’s actual leverage.

Conventional wisdom among leading resea rchers is that

the capital struct ures of individual companies are stable over

long horizons, with rms that cu rrently have high (or low)

leverage tending to have mainta ined high (or low) lever-

age for two decades a nd longer, perhaps even as far back

as the beginning of their existence. is v iew suggests that

companies keep their leverage close to target ratios th at do

not change much over long periods. It has also fostered a

belief that researc hers seeking to understand capital str ucture

should focus on explaining t he allegedly quite stable distribu-

tion of leverage ratios across companies, while largely ignoring

any variation over time in t he leverage of a given company

because such intertemporal va riation is ostensibly noise of

little econom ic importance.²

To what extent is this conventional wisdom about

capital-structu re stability descriptive of publicly held U.S.

companies? In our study of over 15,000 U.S. companies that

was published in the 2015 Journal of Finance, we examined

leverage both over time and across compan ies from a variety of

perspectives to asse ss this fundamentally import ant question.

In this paper, we summariz e highlights of the ndings of that

study on the extent of capital structu re stability, and provide

an exploratory analysis of the sources of the variation over

time in the leverage ratios of publicly held companies.

Conventional wisdom that capital structures are generally

quite stable is far wide of the mark. Instead, our ndings show

that substantial instability in leverage is the norm, with individ-

ual company leverage ratios exhibiting a degree of variability

over time (researchers call it “time-series” variation) that is

comparable in importance to the large variation in leverage

across companies (“cross-sectional” variation). Episodes of lever-

age stability do arise from time to time at particular companies,

but they are the exception, not the rule. Such episodes largely

occur at companies that currently have low leverage, and most

of these cases prove to be temporary. Leverage does tend to be

“sticky” over horizons of a few years. However, it is far from

stable over longer horizons, and a company’s current leverage

becomes an increasingly poor predictor of its future leverage as

the time between leverage observations lengthens.

e main features of capita l structure instability indicated

by our large-sample evidence a re illustrated in Figure 1, which

plots leverage ratios for GM, IBM, and Koda k from 1926

to 2008. Book and market levera ge ratios vary widely over

time at all three rms. Kodak had stable near-zero leverage

for many years, but its leverage skyrocketed in the 1980s

and thereafter rema ined quite volatile. GM was essentia lly

unlevered in 1945, but thereafter its leverage increased

substantially, with a temporary respite of relative stabil-

ity in the 1960s and 1970s. IBM also had relatively stable

leverage during the 1960s and 1970s, sandwiched between

longer periods of much higher and more volatile leverage.

A similar picture of substa ntial leverage cha nges over time

characteriz es the leverage plots back to the 1920s for 21 other

prominent companies that we provide in the Appendix to th is

paper. ese 21 companies, like GM, IBM, and Koda k, were

included at some point in the Dow Jones Industrial Average.

e instability of leverage documented in our study eec-

tively refutes target-rebalancing models of capital structure in

by Harry DeAngelo, University of Southern California, and Richard Roll,

Caltech and University of California at Los Angeles*