A Dynamic Model Of Optimal Capital Structure

This paper presents a continuous time model of a firm that can dynamically adjust both its capital structure and its investment choices. In the model we endogenize the investment choice as well as firm value, which are both determined by an exogenous price process that describes the firm's product market. Within the context of this model we explore cross-sectional as well as time-series variation in debt ratios. We pay particular attention to interactions between financial distress costs and debtholder/equityholder agency problems and examine how the ability to dynamically adjust the debt ratio affects the deviation of actual debt ratios from their targets. Regressions estimated on simulated data generated by our model are roughly consistent with actual regressions estimated in the empirical literature.

This paper presents a continuous time model of a firm that can dynamically adjust both its capital structure and its investment choices. The model extends the dynamic capital structure literature by endogenizing the investment choice as well as firm value, which are both determined by an exogenous price process that describes the firm's product market. Within the context of this model we explore interactions between financial distress costs and debtholder/equityholder agency problems and examine how the ability to dynamically adjust the capital structure choice affects both target debt ratios and the extent to which actual debt ratios deviate from their targets. In particular, we examine how financial distress and the firm's objectives, i.e., whether it makes choices to maximize total firm value versus equity value, influence the extent to which firms make financing choices that move them towards their target debt ratios.

We introduce a model in which risk-free interest rate, firm risk, bankruptcy costs, issuance costs, tax benefits on debt, and earnings ratio, determine the optimal choice of leverage and maturity. The model assumes that debt pays a regular flow of interests, allows the firm to rebalance its optimal capital structure at maturity issuing new debt at par, links tax deductions to the presence of taxable income, and considers default to be an endogenous and time-dependent decision. Simulation results are also provided, with standard leverage ratios, debt maturities, and credit spreads being replicated for reasonable parameter values.

"We put forward a theory of the optimal capital structure of the firm based on Jensen's (1986) hypothesis that a firm's choice of capital structure is determined by a trade-off between agency costs and monitoring costs. We model this tradeoff dynamically. We assume that early on in the production process, outside investors face an informational friction with respect to withdrawing funds from the firm which dissipates over time. We assume that they also face an agency friction which increases over time with respect to funds left inside the firm. The problem of determining the optimal capital structure of the firm as well as the optimal compensation of the manager is then a problem of choosing payments to outside investors and the manager at each stage of production to balance these two frictions"--National Bureau of Economic Research web site.

Capital structure theory is one of the most dynamic areas of finance and forms the basis for modern thinking on the capital structure of firms. Much controversy has resulted from comparisons of the theory of capital structure originally developed by Franco Modigliani and Merton Miller to real-world situations. Two competing theories have emerged over the years, the optimal capital structure theory and the pecking order theory.Arvin Ghosh begins with an overview of the controversies regarding capital structure theories, and then statistically tests both the optimal capital structure and pecking order theories. Using the binomial approach he analyzes the determinants of capital structure while discussing the role of market power in determining capital structure decisions. Ghosh probes the questions of new stock offerings and stockholders' returns, and analyzes capital structure and executive compensation. He then looks into debt financing ownership structure, and the controversal relationship between capital structure and firm profitability. Finally, he discusses the latest developments in the field of capital structure.A concise overview of a major issue in business economics and finance, this volume provides a fuller understanding of capital structure influence on the financial performance of firms, and will certainly stimulate further debate. While hundreds of scholarly articles have been written on the subject this is the first book to test competing theories against measurements of firms' performance and their underlying capital structure.

In this research, we investigate the dynamic of the capital structure, using panel data techniques. A sample of new high-tech German firms over the period 1998-2002 is used to specifically establish the determinants of a time-varying optimal capital structure. We consider the dynamic models, introducing the Anderson and Hsiao (1981) estimators and the critical distinction between fixed and random effects. This is the first time the scope of studying the dynamic of the capital structure has been extended to new high-tech firms with the use of many techniques of panel data. Confirming the pecking order model but contradicting the trade off model, we find that more profitable firms use less leverage. We also find that large companies tend to use more debt than smaller companies, and that firms which have high operating risk can lower the volatility of the net profit by reducing the level of debt. Leverage is also closely related to tangibility of assets and to the ratio of non-debt tax shield. Finally, estimating a dynamic panel data model, we find that new high-tech German firms adjust their target ratio very quickly.

In this paper I present a dynamic model for capital structure. The result of the dynamic panel data estimate is that fixed assets and the lagged-debt variables explain leverage. Conditioning the debt level on the lagged-debt level reveals that the significance of other parameters falls as compared to a static model, and can be interpreted as support for the pecking order hypothesis. I have shown that the capital structure is changing at a slow pace. The firms changes only about 15% of the debt each year. The debt ratio of low and high level debt firms changes more for each year and both low and high debt firms tend to change towards the mean. This finding indicates that the firms set a target level for their debt structure.

The research reported in this volume represents the second stage of a wide-ranging National Bureau of Economic Research effort to investigate "The Changing Role of Debt and Equity in Financing U.S. Capital Formation." The first group of studies sponsored under this project, which have been published individually and summarized in a 1982 volume bearing the same title (Friedman 1982), addressed several key issues relevant to corporate sector behavior along with such other aspects of the evolving financial underpinnings of U.S. capital formation as household saving incentives, international capital flows, and government debt management. In the project's second series of studies, presented at the National Bureau of Economic Research conference in January 1983 and published here for the first time along with commentaries from that conference, the central focus is the financial side of capital formation undertaken by the U.S. corporate business sector. At the same time, because corporations' securities must be held, a parallel focus is on the behavior of the markets that price these claims.

The firm s financing policy is not only influenced by trade-off between the tax advantages of debt financing, recapitalization and financial distress costs but also by exogenous financial developments and liberalization policies. In recent years after the recurrent financial crisis the leverage behaviour has attracted considerable interest as the high debt ration signals out a major cause of financial crisis. The book extends the theoretical study of optimal capital structure by introducing the financial development in the corporate sector in a deterministic capital structure theory. The firm s financing behaviour is described in a dynamic model with firm specific variables and the state of financial liberalization. The study s aim is to propose and test a natural explanation of how financial liberalization might affect financial leverage. If liberalization policy has a significant linkage with financial leverage and it tends to increase use of debt relative to equity financing, this will this will have implications for the likelihood of bankruptcy and for the pace and amplitude of business cycle fluctuations.