Leaning Against the Wind: Debt Financing in the Face of Adversity

• DOI: http://doi.org/10.1111/fima.12227
• Published date: 01 September 2018
• Author: Holger Kraft,Michael J. Brennan
• Date: 01 September 2018

Leaning Against the Wind: Debt

Financing in the Face of Adversity

Michael J. Brennan and Holger Kraft∗

We offer evidence of a new stylized feature of corporate financing decisions: the tendency of

managers to rely more on debt financing when earnings prospects are poor. We term this “lean-

ing against the wind” and consider three possible explanations: market timing, precautionary

financing, and “making the numbers.” We find no evidence in favor of the first two hypotheses,

and provisionally accept the making the numbers hypothesis that managers who are under pres-

sure due to unrealistically optimistic earnings expectations by analysts and deteriorating real

opportunities will rely more heavily on debt financing to boost earnings per share and returnon

equity.

In recent years, the failure of static theories of capital structure to explain observed capital

structure decisions and, in particular,their f ailure to explainthe obser vedslow speed of adjustment

to target capital structures, has lent support to a family of dynamic models of capital structure in

which financing decisions depend not only upon the current level of profitability and f inancial

structure, but also on expectations about future levels of profitability and financing needs. In this

paper, we provide empirical evidence that financing decisions do depend on expectations about

future profitability. Wefind that after allowing for asset growth and mean reversion in profitability,

debt financing has strong predictive power for future changes in profitability as measured by the

Return on Assets. Although asset growth and the total amount of external financing tend to be

associated with higher future profitability, increased reliance on debt financing is associated with

a lower future return on assets. Because the amount of debt financing is a managerial choice

variable, this implies that managers have information about a change in future profitability at the

time of the financing and choose to issue more debt when future earnings prospects are relatively

poor. This behavior, which we term “leaning against the wind,” appears to be inconsistent with

the traditional static tax and bankruptcy model that predicts a decline in debt capacity and

a corresponding decline in debt financing in these circumstances. The relation between debt

financing and future changes in the Return on Equity is much weaker, but in the same direction.

We consider three possible explanations for leaning against the wind: 1) market timing, 2)

precautionary financing combined with pecking order f inancing, and 3) “making the numbers”

(MTNs). The market timing (MT) hypothesis is motivated by the findings on market timing of

Baker and Wurgler (2002) who argue that current capital structures are the result of past efforts

to time the market, and DeAngelo, DeAngelo, and Stulz (2010) who describe market timing as

Wethank Thomas Dangl, Sheridan Titman, and Harry DeAngelo, as well as seminar participants at Bocconi University,

Collegio CarloAlberto, Cambridge University, the National University of Singapore, and WirtschaftsuniversitaetVienna,

for helpful comments on a previous version of this paper that was circulated with the title Financing Asset Growth.

Holger Kraft gratefully acknowledges financial support from Deutsche Forschungsgemeinschaft (DFG) and the Center

of Excellence SAFE, funded by the State of Hessen initiative for researchLOEWE.

∗Michael J. Brennanis an Emeritus Professor in the Anderson School at the University of California Los Angeles in Los

Angeles, CA, and the Manchester Business School. Holger Kraft is a Professorof Finance in the Faculty of Economics

and Business Administration at Goethe University,Frankfurt am Main in Germany.

Financial Management •Fall 2018 •pages 485 – 518

486 Financial Management rFall 2018

“the most prominent theoretical explanation for SEOs (seasoned equity offerings).” The market

timing hypothesis predicts that managers will tend to rely more heavilyon equity f inancing when

they perceive that their stock is overpriced and, as a result, heavy reliance on debt financing

will be associated with underpricing and positive future risk-adjusted stock returns. The market

timing hypothesis has no particular implications for the relation between current debt financing

and future profitability unless changes in future profitability are anticipated by managers, but not

by the market.

We find that in contrast to the prediction of the MT hypothesis, stocks of firms that rely

more heavily on debt to finance their asset expansion have lower future risk-adjusted returns

implying that their stock is more over-valued.Thus, not only does the MT hypothesis not explain

our findings, it poses a further puzzle as to why firms issue more debt when their shares are

overpriced. This question is the more pressing in that debt issuance is most often regarded as

a threat to managerial independence as a result of the need to service the debt out of free cash

flow, the constraints imposed by bond covenants, debtholder monitoring, and even bankruptcy.

In addition, debt financing increases the risk of any stock held by the manager. What then could

make debt financing attractive to managers when the stock is overpriced?

Our second hypothesis is more closely related to the recent dynamic theories of corporate

finance in that it combines the pecking order hypothesis of Myers (1984) with a precautionary

financing motive. We label it the extended pecking order (EPO) hypothesis. The precautionary

financing motive is implied by dynamic capital structure models in which “the firm is forward-

looking, making current investment and financing decisions in anticipation of future financing

needs” (Hennessy and Whited, 2005, p. 1130). The precautionary motive implies that a firm that

anticipates a decline in future profitability will find it advantageous to raise external f inancing

immediately in the expectation that financing costs will be higher in the future. The pecking

order hypothesis of Myers (1984) implies that when external financing is required, firms will

first raise debt financing and only turn to exter nal equity when their ability to issue debt at a

reasonable cost is exhausted. Thus, combining the precautionary motive with the pecking order

hypothesis, a firm that faces a decline in future profitability will tend to raise more external

financing and, because debt is the preferred type of external financing, a greater propor tion of its

total financing will be debt financing. This creates a link between the amount of debt f inancing

and future declines in profitability. Note that under the EPO hypothesis, the link between debt

financing and future declines in profitability r uns through external financing and once account

is taken of the amount of external financing that is raised, there is no reason to expect a marginal

effect of expected future changes in profitability on the amount of debt financing. Contrary to

this prediction, we continue to find a strong relation between the amount of debt financing and

future changes in profitability after taking account of the amount of external f inancing. We also

find that, contrary to the intuition that precautionary f inancing will forecast declines in future

profitability, the amount of external financing is positively associated with the future change in

the Return on Assets.

Our third hypothesis, the MTNs hypothesis, states that financing decisions are influenced

by managerial incentives to meet earnings per share targets. In particular, because executive

compensation schemes do not take explicit account of risk and most compensation contracts

have option like features due to limited liability, a manager has an incentive to increase risk

through leverage and to “roll the dice” when future prospects look relativelypoor. The hypothesis

is motivated by the survey evidence of Graham and Harvey (2001, pp. 189-190) that “when

issuing equity,respondents are concer ned about earnings per share dilution and recent stock price

appreciation.” It is also consistent with the evidence reported by Graham, Harvey, and Rajgopal

(2005) that managers place a very great importance on earnings and not cash flows or other

Brennan & Kraft rLeaning Against the Wind 487

metrics.1The MTN hypothesis is also motivated by the suspicion aroused by public discussions

about bank capital following the financial crisis that managers do not accept the Modigiliani-

Miller framework, and believe instead that equity is more expensive than debt, leading them to

rely more on debt financing when the future returns on investments are expected to be low in

order to achieve their target earnings per share and return on equity targets.2

Unlike behavioral models of corporate finance, the MTN hypothesis does not presume irra-

tionality on the part of either investors or managers. Rather, it assumes that managers are rational,

but that at least a portion of managerial compensation depends upon observable accounting

variables and that managers rationally take account of this in making decisions.

Consistent with the MTNs hypothesis, we find that debt financing tends to increase the Return

on Equity and therefore earnings per share for a given level of the Return on Assets. Holding

constant total asset growth, debt issuance is positively associated with measures of pressure on

managers including over-optimistic analyst forecasts and over-valued stock, as well as poor past

and current operating performance and poorer future operating performance. In addition, debt

issuance tends to be higher ceteris paribus when it has the greatest effect on earnings per share

as the earnings yield is high relative to bond yields. Finally, managers of high debt issuing firms

tend to be more recently appointed and to have shorter future tenures.

Our findings have implications for the controversial issue of corporate capital structure. We

take the view advanced by Myers (1984) and Baker and Wurgler (2002) that corporate capital

structures are the result of past financing decisions. Thus, the best way to understand current

capital structures is to analyze the financing decisions that gave rise to them. Our main contribution

is to provide empirical evidence of a link between corporate financing decisions and managerial

incentives and to demonstrate how this link provides an explanation for the poor returns that are

realized by firms that rely heavily on debt to finance their asset growth. We do not claim that this

is the whole story of financing decisions. Undoubtedly, other considerations also are at work. As

Myers (2002, p. 217) remarks “There is no universal theory of capital structure, and no reason

to expect one [ ...]Each factor could be dominant for some firms or in some circumstances,

yet unimportant elsewhere.” Therefore, given that the empirical evidenceis inconsistent with the

first two hypotheses, we provisionallyaccept the MTNs hypothesis which predicts that managers

who are under pressure due to unrealistically optimistic earnings expectations by analysts and

deteriorating real opportunities, will rely more heavilyon debt f inancing in order to boost earnings

per share and the return on equity.

The paper is organized as follows. In Section I, wepresent the basic evidence of leaning against

the wind behavior. Section II develops empirical predictions from the three basic hypotheses.

Section III describes related literature, whereas Section IV describes the data. Section V is con-

cerned with the extended pecking order hypothesis. Section VI demonstrates that debt financing

1Our results indicate that chief financial officers (CFOs) believe that earnings, not cash flows, are the key metric

considered by outsiders. The two most important earnings benchmarks are quarterly earnings for the same quarter last

year and the analyst consensus estimate. Meeting or exceeding benchmarks is very important. Managers describe a trade-

off between the short-term need to deliver earnings and the long-term objective of making value-maximizing investment

decisions. Executives believe that hitting earnings benchmarks builds credibility with the market and helps to maintain

or increase their firm’s stock price. Theyalso repor t that “Second,managers are interested in meeting or beating earnings

benchmarks primarily to influence stock prices and their ownwelfare via career concerns and external reputation, and less

so in response to incentives related to debt covenants, credit ratings, political visibility, and employee bonuses that have

traditionally been the focus of academic work.” Matsunaga and Park (2001) find that failure to meet analysts’ consensus

estimates results in pay cuts for the CEO.

2For example,the Chair man of Deutsche Bank, Josef Ackermann (2010), was quoted as sayingthat “Demands for Tier-1

capital ratio of 20% [...] could depress ROE to levelsthat make investment into the banking sector unattractive relative to

other business sectors.”