A Model of Capital Structure when Earnings are Mean-Reverting

Raymar, Steven

doi:10.2307/2331210

Cited by 24 publications

(31 citation statements)

References 36 publications

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“…The effect of the coupon C is also different from Raymar (1991), who found bond value to be an increasing function of C . In our model, bond value is initially an increasing function of C but subsequently a decreasing function of C, as shown in Figure 1.…”

Section: 2 Debt Valuationmentioning

confidence: 56%

“…He derived the optimal leverage ratio when the company issues only short‐term (single‐period) debt, with the debt level being readjusted every period, and shows that the optimal leverage ratio is an increasing function of current earnings. ‘Over time, our model predicts that when earnings are above (below) average, leverage should be so as well’ (Raymar, 1991, p. 328). Thus, Raymar's main result is also inconsistent with empirical regularities.…”

Section: The Recent Literaturementioning

confidence: 97%

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The Trade‐off Model with Mean Reverting Earnings: Theory and Empirical Tests

Sarkar

Zapatero

2003

The Economic Journal

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The 'trade-off theory' of capital structure predicts a positive relationship between earnings and leverage, contradictory to well established empirical evidence. Since corporate earnings are known to be mean reverting, we reformulate the trade-off model with mean reverting earnings. We show that, with mean reverting earnings, there should be a negative relationship between optimal leverage and the current earnings level. The model also illustrates the importance of the earnings reversion parameter in the determination of capital structure. The major implications of the model are supported by empirical tests carried out with a sample of firms in the S&P 500 Index.The capital structure decision is arguably one of the most important issues in corporate finance. Beginning with the irrelevance propositions of Miller and Modigliani (1958), there is a substantial literature on what Myers (1989, p. 80) calls 'the search for optimal capital structure'. In the theoretical literature, there are two major competing models, the traditional 'trade-off theory' and the more recent 'pecking order hypothesis'. According to the former, firms choose an optimal leverage ratio by balancing the tax benefits of debt against the costs associated with debt, e.g., bankruptcy costs or financial distress costs. The pecking order hypothesis is based on informational asymmetry between insiders (managers or shareholders) and outsiders. According to this theory, firms tend to raise funds in the following order of preference: internal finance (retained earnings), safe debt, risky debt, and finally equity.Certain implications of the trade-off theory have received empirical support; see, for example, Long and Malitz (1985), Mackie-Mason (1990) and Graham (1996). However, in a head-to-head comparison between the two theories, the pecking order model seems to be more favourably viewed than the trade-off theory (Baskin, 1989;Shyam-Sunder and Myers, 1999;Fama and French, 1999). To quote Fama and French (1999, p. 3) '… we identify one big contradiction of the trade-off model and one less serious contradiction of the pecking order model.' The 'big contradiction' is the earnings-leverage relationship. The actual relationship between leverage and earnings (or profitability) has been found to be negative (Titman and Wessels, 1988;Baskin, 1989;Rajan and Zingales, 1995;Fama and French, 1999). But according to the received wisdom, the trade-off theory predicts a positive relationship between leverage and earnings; see Brealey and Myers (1996), Shyam-Sunder and Myers (1999) etc. To quote Myers (1989, 'the * This paper was presented at the 2001 Rutgers Conference on Capital Structure, Lancaster University, McMaster University, and University of Southern California. We appreciate comments received from participants at these seminars, as well as Peter McKay, Mark Weinstein and especially David Mauer. We also thank two anonymous referees for their feedback and for many useful suggestions, and the editor Mike Wickens for his guidance. Finally, we thank John Graham...

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Section: 2 Debt Valuationmentioning

confidence: 56%

Section: The Recent Literaturementioning

confidence: 97%

The Trade‐off Model with Mean Reverting Earnings: Theory and Empirical Tests

Sarkar

Zapatero

2003

The Economic Journal

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“…We would like to point out that, with mean reverting output price, uncertainty is not measured solely by price volatility r. As pointed out in the ''mean reversion" literature (Raymar, 1991;Sarkar and Zapatero, 2003), the speed of reversion j also affects uncertainty, since a higher j reduces uncertainty by pulling the price back faster to the long-run mean level. Fig.…”

Section: Comparative Static Resultsmentioning

confidence: 93%

Commodity betas with mean reverting output prices

Hong

Sarkar

2008

Journal of Banking & Finance

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“…A possible way to bypass the problem of making estimates and inferences with single-company time series data is to reduce the number of parameters to be estimated. Given that the main interest here is in making inferences on the SOA, we can assume, without loss of generality, that PO/MT and TO determinants are summarized by two variables which admit a valid autoregressive (AR) representation: Raymar (1991) and Sarkar and Zapatero (2003) introduce theoretical models where earning processes are heterogeneous but mean-reverting; Alti (2006) shows that the impact of MT on leverage vanishes at the end of the second year: such limited persistence of MT shocks justifies the stationary assumption on a i (L) polynomials.…”

Section: Extending the State-of-art Models To Heterogeneity Under Altmentioning

confidence: 99%

Dynamic Corporate Capital Structure Behavior: Empirical Assessment in the Light of Heterogeneity and Non Stationarity

2015

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Understanding the dynamics of the leverage ratio is at the heart of the empirical research about firms' capital structure, as they can be very different under alternative theoretical models. The pillars of almost all empirical applications are the maintained assumptions of poolability and stationarity, which are motivated by the need of model's simplicity and treatability, rather than being based on an empirical ground. In this paper we provide robust evidence of non-stationarity for a significantly large share of US firms' debt ratios and of strong heterogeneity in the speeds at which firms adjust towards their targets. These results stimulate new directions of the empirical research on debt ratio dynamics by relying more on the concept of heterogeneous degree of leverage persistence.

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A Model of Capital Structure when Earnings are Mean-Reverting

Cited by 24 publications

References 36 publications

The Trade‐off Model with Mean Reverting Earnings: Theory and Empirical Tests

The Trade‐off Model with Mean Reverting Earnings: Theory and Empirical Tests

Commodity betas with mean reverting output prices

Dynamic Corporate Capital Structure Behavior: Empirical Assessment in the Light of Heterogeneity and Non Stationarity

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