Are Estimates of Target Capital Structures Meaningful? Evidence from International Data

In a study published recently in the Journal of Risk and Financial Management, the authors of this book chapter assessed leverage and debt maturity targeting in a large international setting. Prior studies have similarly evaluated whether firm actions inferred from various leverage models are consistent with the predictions of the theory. The earlier studies testing the tradeoff theory of capital structure typically regress observed leverage ratios on the proxies for the costs of financial distress and agency conflicts and tax benefits of debt with the idea that the model is a good first order approximation of the equilibrium. This approach is problematic since firms do not typically operate at their optimal leverage due to financial frictions, indicating that the observed capital structure is a noisy proxy of target capital structure. In contrast to this traditional approach, the study proposed a new empirical test of target behavior based on capital structure targets and target deviations. If the estimated capital structure targets are relevant, the influence of factors such as bankruptcy costs, agency costs, and information asymmetry costs on firms’ target capital structures should be congruent with the theory. Furthermore, a firm that is not at the leverage target should take actions that adjust toward the target to close its deviation from the target. These actions should differ across firms depending on their environment, as different conditions require firms to react to shocks differently. The theory would be reliable to the extent that it correctly predicts the determination of the capital structure targets and target deviations based on the institutional, financial, and macroeconomic environment in which the firm operates. Thus, while the prevailing debate about the role of national institutions is focused around observed leverage and observed debt maturity as a proxy for optimal leverage and optimal debt maturity, the study estimated optimal leverage and optimal debt maturity with various reliable empirical models and used these estimates as its key measures in subsequent tests. The authors documented that there are key differences in the relative importance of institutional factors in explaining actual as opposed to target capital structures. Targets and target deviations are plausibly influenced by the institutional environment. Firms from countries with strong legal institutions target lower leverage and higher long-term debt, whereas better-functioning financial systems result in lower target leverage and long-term debt. Financial crisis has shifted the desired structure of the securities toward shorter maturities and has led to more prevalent target deviations. Better institutions significantly decrease the likelihood of target deviations. The variation in external financing costs, as captured by the quality of legal institutions, the financial development of the country, and the financial crisis times, is an important driver of target deviations.