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

The writers of this book chapter examined leverage and debt maturity targeting in a large international environment in a research published recently in the Journal of Risk and Financial Management. Prior research has looked at whether firm actions inferred from various leverage models are consistent with the theory’s predictions. Earlier research examining the tradeoff theory of capital structure regressed observed leverage ratios on proxies for the costs of financial distress, agency conflicts, and debt tax benefits, under the assumption that the model is a good first order approximation of the equilibrium. Due to financial frictions, firms do not often function at their optimal leverage, implying that the observed capital structure is a noisy proxy for the goal capital structure. The study provided a new empirical test of target behaviour based on capital structure targets and target deviations, which differed from the usual approach. If the predicted capital structure objectives are accurate, the impact of issues like bankruptcy, agency, and information asymmetry costs on firms’ target capital structures should be consistent with the theory. Furthermore, a company that is not at the leverage objective should take steps to move closer to the target. These behaviours should vary each firm depending on their environment, as different circumstances necessitate varied responses to shocks. The theory would be reliable if it accurately predicted the capital structure targets and target deviations depending on the firm’s institutional, financial, and macroeconomic context. While the current debate over the role of national institutions is centred on observed leverage and observed debt maturity as proxies for optimal leverage and optimal debt maturity, the study estimated optimal leverage and optimal debt maturity using a variety of reliable empirical models and used these estimates as key measures in subsequent tests. The authors found that the relative impact of institutional determinants in explaining actual vs desired capital structures differs significantly. The institutional context is likely to influence targets and target deviations. Firms in nations with strong legal institutions aim for lower leverage and more long-term debt, while those in countries with better financial systems aim for lower target leverage and long-term debt. Because of the financial crisis, the desirable structure of securities has shifted toward shorter maturities, resulting in more frequent target deviations. Target deviations are substantially less likely in better institutions. Variations in external finance costs, as measured by the quality of legal institutions, the country’s financial development, and financial crisis periods, are a major driver of target deviations.

Author(S) Details

Ali Gungoraydinoglu
College of Business, Florida International University, 11200 S.W. 8th St., Miami, FL 33199, USA.

Özde Öztekin
College of Business, Florida International University, 11200 S.W. 8th St., Miami, FL 33199, USA.

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