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A Growth Type Explanation for Capital Structure Persistence

A Growth Type Explanation for Capital Structure Persistence. Xueping Wu and Chau Kin Au Yeung City University of Hong Kong. Presented at NTU on December 11, 2008, Taiwa n. Motivation. A: Unobserved firm heterogeneities. E xisting theories Our main idea A Growth Type S tory

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A Growth Type Explanation for Capital Structure Persistence

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  1. A Growth Type Explanationfor Capital Structure Persistence Xueping Wu and Chau Kin Au Yeung City University of Hong Kong Presented at NTU on December 11, 2008, Taiwan

  2. Motivation • A: Unobserved firm heterogeneities

  3. Existing theories • Our main idea • A Growth TypeStory • Empirical: Persistence across growth types • leverage ratios • important firm fundamentals • financing activities • Our view about market timing • Horse race: growth type vs. market timing • Conclusion Road Map

  4. Competing Capital Structure Theories • Tradeoff theory • Pecking order • The market timing argument of Baker and Wurgler (2002) • Can they explain leverage persistence? Literature

  5. Focus on costs & benefitsof debt finance • Target leverage  Graham and Harvey (2001): Yes in survey • Tradeoff force= adjustment toward target (optimum)  An increase in debt has Benefits: Tax shield, Disciplining role (for FCF) Costs: Assets substitution (opportunism), Financial distress, Debt overhang 1. Tradeoff Theory

  6. Persistence = Target leverage? • Conceptually, stay where you are ≠ at the target • Tradeoff force? • Titman & Wessels(1988);Rajan&Zingales(1995): Profitability↑  leverage↓ (the big scar!) • Graham (2000): Debt conservatism • Fama andFrench (2002): “Snail” speed of adj. • Chang & Dasgupta (2007): Mechanical Mean Reversion Tradeoff Theory (Problems)

  7. Focus on costs of equity finance • Myers and Majluf (1984): adverse selection effect • Financial slack is valuable, weakening tradeoff force (explaining the big scar in tradeoff theory.) • Myers (1984): Pecking order in financing  Retained earnings < Debt < Equity (as the last resort)  Asymmetric Informationcosts • Slow adj., no target (persistently kept away) 2. The Myers (1984) Pecking Order

  8. Equity as last resort? • Small growth firms issue a lot of new equity Rajan&Zingales(1995), Famaand French (2002) andFrank and Goyal (2003) • Why no fear for the AI/adverse selection effect?  The last resort puzzle (the deep wound!) The Pecking Order (A Problem)

  9. Baker andWurgler (2002) • Capital structure is a result of past attempts to time the market(especially via equity issues) • Market timing is driven by overvaluations (cheap equity, Stein, 1996). • So equity is not necessarily the last resort • Like in Myers (1984): slow adj., no target 3. Market Timing

  10. Leary and Roberts (2005): • Clustered quick rebalance • Hovakimian (2005); Kayhan and Titman (2006): • Wrong interpretation by Baker and Wurgler • Lemmon, Roberts & Zender (2008): • Leverage persistence: initially determined • But, Huang & Ritter (2007): Address cheap equity!  Behavior finance: Overvaluation = Cheap new equity 3. Market Timing (Debate)

  11. MM Theorem: If capital markets are imperfect, capital structure matters. • Persistent agency conflicts and AI types across firms (persistent relative agency/AI costs)  Persistently distinct market imperfections across firms • Persistently distinct financing behavior (and capital structure) in response • A type-determination storyfor leverage persistence This Paper’s View

  12. Baby » Adult: We observe persistent characteristics, e.g., heavy vs. thin • Gene determination: diet behavior is gene-driven  A heavy kid/adult always eats a lot.  A thin kid/adult cannot eat much. • The analogy: Gene = Persistent type behind leverage Diet behavior = Financing (incl. market timing) An Analogy of Type Determination

  13. Asymmetric Information (AI) arises from Assets-in-place (AIP) Growth (NPVGO) (1) Asset Type (Myers, 1977):Tangibles vs. Intangibles (2) AI Type (correlated with Asset Type in reality): Myers and Majluf (1984) • Type A: more AI about AIP than about growth • Type B: more AI about growth than about AIP Asset Type and Asymmetric Info Type

  14. AI Types and Financing Patterns  The generalizedMyers-Majluf Model Cooney & Kalay (1993) and Wu & Wang (2005)

  15. Growth Type and Cost of Capital  A description of agency and asymmetric information costs based on Myers (1977) and the generalized MyMj model

  16. Lemmon, Roberts & Zender (2008) • Initially determined (implying a type story) 2. This paper suggests • Growth type gives rise to persistently distinct market imperfections across firms • Growth type preset persistently distinct financing behavior in response Thus: • Growth type explains leverage persistence parsimoniously. • Market Timing is a growth-type driven phenomenon A Growth Type Story for Leverage Persistence

  17. CompuStat US non-utility & non-financials • 1971-2005 • Initial value: average of event year 0, 1, 2. • With breakpoints at medians, two way independent sort on initialmarket-to-book and initialtangibility Test Design: Initial Growth Type

  18. Fig. 1A: Group Mean Book Leverage with the IPO Sample (1971 – 2005)

  19. Fig. 1B: Group Mean Market Leverage with the IPO Sample (1971 – 2005)

  20. Fig. 1C: Group Mean Book Leverage with the Full Sample (1971 – 2005)

  21. Fig. 1D: Group Mean Market Leverage with the Full Sample (1971 – 2005)

  22. Table 3: Long Lived Effects of Initial Growth Type -- Event Time Cross-sectional OLS • Initial MtB overwhelms updated MtB in the long run. • Updated Tang overwhelms initial Tang eventually.

  23. Table 3: Long Lived Effects of Initial Growth Type (cont’d) • Initial growth type (especially via initial MtB) has a strong long lasting effect!

  24. Table 4: How Stable is GT with Updated Tangibility? • The dominant diagonal effect indicates stable growth type.

  25. Fig. 2A: Group Mean Book Leverage with Full Sample in Calendar Time

  26. Fig. 2B: Group Mean Market Leverage with Full Sample in Calendar Time

  27. Fig. 3A: Industry-adjusted Book Leverage with Full Sample in Event Time

  28. Fig. 3B: Industry-adjusted Market Leverage with Full Sample in Event Time

  29. Fig. 3C: Industry-adjusted Book Leverage with Full Sample in Calendar Time

  30. Fig. 3D: Industry-adjusted Market Leverage with Full Sample in Calendar Time

  31. Table 5: Significance of Differences in Leverage Between the Growth Types

  32. Table 6: Persistent Firm Fundamentalsacross the Growth Types  Growth types are persistently distinct.

  33. Table 6: Persistent Firm Fundamentals (cont’d 1) • Firm size: G1 > G2 > G3 (Gaps persist.) • Profitability:G1 > G2 > G3 (stable  bumpy)

  34. Table 6: Persistent Firm Fundamentals (cont’d 2) • Among profitable firms: G1<G2> G3 • Among loss-making firms: G1 > G3  G3: smaller-sized with the largestdispersion in profits skewed towards losses

  35. Table 6: Persistent Firm Fundamentals (cont’d 3) • Annual sales growth (SGR): G1 < G2 < G3  G3 firms do deliver the highest sales growth.

  36. Table 6: Persistent Firm Fundamentals (cont’d 4)  Distinct investment styles: • Tangible Investment (Capex): G1 > G2 > G3 • Intangible investment (R&D): G1 < G2 < G3 • G1 = tangible-growth type; G3 = intangible-growth type  Persistently large R&D for G3 supports its high market to book and high sales growth rate.

  37. Table 6: Persistent Firm Fundamentals (cont’d 5) • Cash Holdings: G1 < G2 < G3 • %Payers: G1>G2>G3 G1: low cash holdings and typical div payers G3: high cash holdings and typical div non-payers

  38. How about Funding Activities? Fig. 4A: Net Debt Issue by Initial Growth Type  Little differences here

  39. Fig. 4B: Net Equity Issue by Initial Growth Type • Difference in Net Equity Issues: G1 < G2 << G3 Heavy equity finance is a growth type phenomenon.

  40. Fig. 4C: Change in Retained Earningsby Initial Growth Type • Difference in RE Changes: G1 > G2 >> G3 (negative!) G3 firms grow largely through equity financing.

  41.  For G3, heavy losses, due to the expensing of large R&D investments that pay off slowly, offset new equity issues.

  42. Traditional, rational Views • (No ex ante under-/over-valuation) • Irrational or behavioral view • MT is driven purely by market overvaluation • Generalized View (Rational, Type-based View) Market Timing (MT)

  43. Market conditions drive equity issue spikes (MT) (e.g., Market-to-book, stock price run-ups) (1a) A decrease in AI of AIP (Korajczyk, Lucas, McDonald, 1990, 1993; Choe,Masulis, and Nanda, 1993) (1b) A decrease in the adverse selection effect due to project delay ability (Lucas & McDonald, 1992) • Both are rational views but are silent about σ(growth opportunities)↑. (1) Traditional Views

  44. Two different views onthis observation: σ(growth)↑equity issuing costs↓ (2) Behavioral view Stein (1996), Backer and Wurgler (2002) • Exploitable market timing based on Overpricing& dumb equity investors (Stein, 1996) (3)The generalized MyMj view Cooney and Kalay (1993); Wu and Wang (2005)  Type-based fair market timing How about Growth Uncertainty?

  45. Implications of market conditions (MtBt) Type A: AI mainly about assets-in-place MtBt↑ AIt↓  Equity issuet↑ Type B: AI mainly about growth opportunities MtBt↑  AIt↑  Equity issuet↑ • “Fair”=Rational expectation is imposed. Growth-type-based Fair Market Timing

  46. Table 7: D and E Issues by IGTFull sample 1971-2005, Pooled OLS with Firm FE • Fair market timing: during market upturn, MtBt↑  AI about AIP ↓ (good for G1),and AI about growth ↑ (good for G3)  A growth-type-based pecking order in financing Baker and Wurglar (2002): Low (high) leverage firms tend to raise fund when their valuations are high (low). (Untrue!)

  47. Table 7 (cont’d): D and E Issues by Growth Type • Profits: A tradeoff force for debt issue at G1 but weak at G3. • Size: A maturity effect (external finance↓, but on diff. paths)  Taken together: Growth-type determined dynamic external finance

  48. Baker and Wurgler’s (2002) For each firm at t: • es=net equity issue in event year s • ds=net debt issue in event year s • Two-Horse Race: (1) B&W MtBefwa, t-1 (Baker-Wurgler MT factor) versus (2) Initial MtB efwa, t-1: (our growth-type-based variant)  The same weighting scheme but with time-varying annual M/Bs being replacedby initial MtB  It is better than the trailing average MtB, as suggested in the literature: confounded by long-term (or average) market timing Horse Race: Growth Type vs. MT

  49. Table 8: Horse Race(OLS a la Baker and Wurgler, 2002, Y=book average)

  50.  It is growth type and not market timing that best explains capital structure.

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