Is Capital Structure Relevant? An Empirical Examination of Capital Structure Choices

Modigliani and Miller propose a scenario in which capital structure becomes irrelevant. To achieve the condition of capital structure irrelevance, Modigliani and Miller have to assume market frictions such as taxes, information asymmetry, and other factors do not exist. With the acknowledgement of such forces, capital structure irrelevance does not hold and we are left with the question “why do firms finance the way that they do?” Within this dissertation I address this very question. Chapters one and two provide an introduction and review of the extant literature. Chapter three examines data over a period of 1970 to 2010, with the goal of identifying which determinants influence capital structure and over what interval of time do the determinants influence capital financing. As tax rates, information costs, and related factors change over time, there is the expectation that determinants change as well. The results indicate that capital structure determinants and the magnitude of their influence do change over time. The change is attributable to factors such as change in regulation and tax rates. The findings provide support for the pecking-order theory prior to 1986 and offer evidence to support the market-timing and trade-off theories. Chapter four employs tests of capital structure theory to identify which theory explains the majority of firm financing decisions and over what period are the theories applicable. The results indicate that the pecking-order theory is the predominant financing regime from 1970 to 1987 and after 1987 the trade-off model is the principal method of capital financing. The analysis also explores speed of adjustment and the results support for the trade-off theory and cast doubt on the market-timing theory. Chapter five responds to highly cited studies that report leverage does not add value, but rather reduces firm value. A stochastic frontier model is employed to assess the relationship of leverage among other factors with firm value. The findings reconcile the prior reports and show that the inverse relationship between leverage and firm value was a temporary occurrence and is likely attributable to firms employing tax loss carrybacks in response to the 1986 Tax Reform Act